A Primer on Agency REITs and 6 That Currently Yield Over 12%

by: Zvi Bar
In this low interest rate environment, many investors and trustees are looking for higher yielding equities to include in a fixed income portfolio. One popular option offering dividends that are significantly above average is the agency mortgage REIT. Agency mortgage REITs possess very interesting advantages and risks that make them, in many ways, different from most other REITs or equities.

What Is an Agency Mortgage REIT?

Most REITs are equity REITs that own office buildings, shopping centers, apartment buildings, hospitals and other properties. Mortgage REITs, to the contrary, own mortgages on real estate assets rather than the assets themselves. Some mortgage REITs concentrate on commercial property mortgages, while others concentrate on residential property mortgages.

Within the world of residential mortgage REITs, there are two primary subdivisions: those that own mortgages insured by federal agencies and those that own mortgages without agency insurance. Agency mortgage REITs are supposed to have portfolios made up principally of mortgages insured by the federal agencies Fannie Mae, Freddie Mac and/or Ginnie Mae.

These government agencies make mortgages and then issue a mortgage backed security (MBS). An agency MBS, as opposed to an MBS issued by a non-agency lender, comes with an agency guarantee and an implied U.S. government guarantee. These federal agencies’ implied or quasi-government guarantees have, so far, been proven virtually as solid as any paper issued directly by the Treasury.

The U.S. government has preferred to bail-out the agencies that are now effectively bankrupt. As borrowers default on these agency loans, the agencies continue to either pay on their behalf or buy out the defaulted loan from the owner(s). Buying out loans can have a volatile affect upon the agency REIT's quarterly income, yield and asset valuation.

REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level. Under the current tax laws, REIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate. Because these REITs must give away so much income, they cannot grow through retaining and re-deploying earnings. As a result, these REITs often choose to place secondary offerings in order to raise capital and increase market valuation. Such actions can be either dilutive or accretive to actual share value depending on how productive the REIT is at using the acquired funds; this can also make the quarterly payout volatile.

Because these REITs are taxed as ordinary income to inve, many investors appreciate holding them in tax-sheltered accounts, such as an IRA. In such an account, the higher tax-rate is less of a concern, if any, though it could affect other shareholders and their actions can affect an IRA holder’s share value.

Examples of Agency REITs

Through screening I have identified several companies that primarily invest in agency paper using the above-described REIT model. Below, listed in alphabetical order, are six such REITs with several vital statistics:

  1. Annaly Capital Management, Inc. (NYSE:NLY)
    • Current Yield: 14%
    • Market Value: $14.2 Billion
    • Debt: $81.52 Billion
    • Price to Book Value: 1.1
    • Short Interest: 4.8%
  2. American Capital Agency Corp. (NASDAQ:AGNC)
    • Current Yield: 18.9%
    • Market Value: $3.8 Billion
    • Debt: $22.15 Billion
    • Price to Book Value: 1.1
    • Short Interest: 5.6%
  3. Anworth Mortgage Asset Corporation (NYSE:ANH)
    • Current Yield: 13.9%
    • Market Value: $894.7 Million
    • Debt: $7.01 Billion
    • Price to Book Value: 1
    • Short Interest: 5.5%
  4. Capstead Mortgage Corp (NYSE:CMO)
    • Current Yield: 12.57%
    • Market Value: $998 Million
    • Debt: $9.57 Billion
    • Price to Book Value: 1.1
    • Short Interest: 4.4%
  5. Cypress Sharpridge Investments (NYSE:CYS)
    • Current Yield: 19.2%
    • Market Value: $1.02 Billion
    • Debt: $5.37 Billion
    • Price to Book Value: 1.06
    • Short Interest: 8.9%
  6. Hatteras Financial Corp (NYSE:HTS)
    • Current Yield: 13.9%
    • Market Value: $2.1 Billion
    • Debt: $11.55 Billion
    • Price to Book Value: 1.1
    • Short Interest: 7.3%

Agency Paper Risks

Washington has not yet developed a reasonable substitute to the current system that, arguably, should have never existed. Still, its existence cannot be denied and government interaction within the mortgage world is unlikely to completely decouple. Any future change to the industry could conceivably shut down this portion of the REIT industry, if the future supply of agency paper is eliminated.

Agency mortgage REITs must also react to changing interest rates. These REITs obtain their lofty yields through high leverage. These companies all have far more debt than their market value, as indicated above, and make money off the spread between their borrowing costs and the MBS interest payment. Each company has a proprietary allocation of fixed and adjustable rate securities. Changes in rates will affect the value of these securities and the spreads these REITs can make off of them. In short, rising interest rates will largely reduce spreads and values.

Further, please note the reasonably high short positions on several of these names. Many investors believe either an interest rate change or second real estate correction is in order. Opinions differ on this asset class and are certainly welcome.

Disclosure: I am long NLY, which I own in my Roth IRA.

Disclaimer: Data is derived from company filings. Yield is but one consideration in choosing an investment, and each investment should be considered relative to the total portfolio and its objectives.