I have written three articles on real estate investment trusts which invest primarily in mortgage and debt instruments (Mortgage REITs) and I thought I had pretty much covered the waterfront (although not in the depth it deserves). However, I have discovered that I have overlooked several mortgage REITs and, for that, I apologize to my readers. In this article, I will briefly review these six companies, but before doing that, I should review a few important facts about the group.
Mortgage REITs generally own mortgages and other debt instruments and frequently employ leverage -- that is, they borrow money so that they can own an amount of assets larger than their equity. An important source of profit is the "spread" between the interest they earn on the mortgages and the interest they have to pay on borrowings. As a general matter, the amount of leverage varies inversely with the riskiness of the asset base. A mortgage REIT that owns government agency-backed mortgage securities generally uses a great deal of leverage because of the low risk of default on the securities. A mortgage REIT that owns mortgages on commercial property generally does not employ as much leverage.
Commercial mortgage REITs and some residential mortgage REITs often use special purpose entities (SPEs) -- essentially separate business entities -- which hold large amounts of mortgages and issue debt instruments to investors. The mortgage REIT retains a subordinate interest and management of the SPE, but the first payments of interest and principal have to be returned to the holders of the debt instruments. These debt instruments are typically non-recourse; that is, the investors are not entitled to seek recovery from any source other than the SPE, and thus are not really obligations of the REIT itself. However, for accounting reasons, the financials of many SPEs are often consolidated into the income statement and balance sheet of the REIT, making the calculation of leverage, book value, and other key metrics extremely difficult.
The mortgage REIT sector has seen an enormous flurry of activity this year in the form of secondary equity offerings, debt restructuring and at least one thwarted takeover attempt. Lots of money is flowing into the sector; experience tells us, this can be dangerous. Investors should not necessarily be enraptured by high dividend yields, as they come with certain risks. On the other hand, I think that the sector still offers some very attractive opportunities for dividend investors and certain limited opportunities for investors seeking substantial price appreciation.
With respect to each of these companies, I will provide the symbol, Tuesday's closing price, the dividend yield (based on prior 12 months' dividends) and the leverage (the ratio of total assets to equity).
- Armour Residential (NYSE:ARR) ($7.66) (19%) (10.7::1)
- Ellington Financial (NYSE:EFC) ($22.70) (11%) (6::1)
- CreXus Investment (NYSE:CXS) ($11.48) (8%) (1.4::1)
- Cypress Sharpridge Investments (NYSE:CYS) ($12.49) (19.4%) (9::1)
- Apollo Commercial Real Estate Finance (NYSE:ARI) ($16.43) (9.8%) (3::1)
- RAIT Financial (NYSE:RAS) ($2.29) (1.4%) (3::1) (leverage includes non-recourse debt)
ARR and CYS are agency mortgage REITS. Within the group, they have relatively high leverage and have also achieved relatively high dividend yields. ARR is heavily invested in adjustable rate mortgages (ARMS) and so may be in a better position than some others in the agency mortgage REIT group to withstand the impact of higher interest rates (if they ever come).
EFC is an unusual hybrid that bills itself as pursuing opportunistically attractively-priced debt instruments of virtually all kinds. It seems to have a concentration in residential mortgage instruments and securities, but can invest in commercial property mortgages and other debt instruments. It seems to be run by some math whizzes. Anyhow, I am impressed by its eclectic approach and definitely have EFC on my watch list.
The other three are commercial mortgage REITs. RAS has had problems and has gone through the 2008-09 "valley of death" and seems to be a survivor. Its stock took a beating in March, apparently due, in part, to the issuance of convertible debt. I think that this was probably not justified, since a lot of the money raised was used to pay off other convertible debt and since the conversion price is higher than the current market price of the stock. RAS also owns some properties, so it is not strictly a mortgage REIT -- although the vast bulk of its assets are mortgages. It has numerous SPEs and this makes an analysis of book value complex.
In calculating leverage for RAS, I have included all assets and debt and, since most of the debt is non-recourse, this tends to make RAS look riskier than it really is. RAS is certainly not attractive on a dividend yield basis at this time; the opportunity is more in the form of capital appreciation. Assuming a solid recovery, RAS could move up substantially. RAS is definitely on my watch list, especially at its current depressed price.
ARI is also a commercial mortgage REIT and will release earnings tomorrow, so I will try not to say anything that will immediately make me appear to be stupid. ARI has been active under the TALF program. Thus far, it seems to simply buy assets on its own balance sheet and has apparently not set up SPEs. It appears reasonably valued and there is reason to believe that the TALF program can create opportunities to buy assets at a nice discount.
CXS has been in the news. In March it turned down a takeover offer at $14 a share (quite a bit higher than where it is now) and instead launched a secondary offering that raised a lot of capital at $11.50 a share. It will deploy the capital to buy a very large portfolio of loans from Barclays. CXS is managed by a subsidiary of Annaly Financial (NYSE:NLY), which is the largest of the agency REITs. I am long CXS on the theory that it is priced reasonably based on the $14 offer and the likely perception of the NLY guys that the Barclays portfolio provides significant upside potential.
The surge of money flowing into mortgage REITS (and the similar surge of money flowing into business development companies) could be somewhat of a danger sign. It is certainly a sign that the mechanism for transmission of yield from mortgage debtors to income investors is shifting away from banks and toward specialty financial companies.
The Federal Reserve's expansive policy is inducing yield-hungry investors to buy up BDC and mortgage REIT stock; this is creating more lending capacity for small business and property owners. While it is almost inevitable that there will begin to be a competition for higher yields through leverage, ending in some nasty surprises, it is also remarkable how the economy has adjusted itself and produced a dynamic and growing mechanism for the transmission of yield.
As I have said before, I think that a lot of the easy money has been made and investors should be careful. Nevertheless, mortgage REITS can play an important part in a dividend investor's strategy.
Disclosure: I am long CXS, NLY.