A Non-Agency REIT Primer: 7 That Currently Yield Over 11%

Includes: CIM, DX, IVR, MFA, RWO, RWT, WAC
by: Zvi Bar
In A Primer on Agency REITs, I reviewed agency mortgage REITs. In this article, I would like to discuss their sibling asset-class: non-agency residential mortgage REITs, and introduce the method by which I analyze their value. Non-agency REITs are usually more diversified, but also present more risk. Additionally, several non-agency REITs do also hold positions in agency mortgages.
Without the agency guarantee, non-agency debt tends to pay a higher interest rate and offer these REITs a larger spread than agency REITs. Of course, this higher return comes with default risk, which is significant in the present market. Some non-agency debt is collateralized by the underlying property, while other debt is non-recourse. Non-agency REITs also employ differing levels of leverage and hedging techniques. All these issues add risk and uncertainty to the asset class.
Several non-agency lenders used loose lending practices through the past decade, which caused a great deal of default and other systemic issues we witnessed from 2007 until today.
Types of Non-Agency Mortgages

(1) Prime mortgages: High-quality mortgages that meet rigorous underwriting requirements, similar to those used for agency mortgages. Such loans are usually non-agency because the balances are above what Fannie and Freddie allows. Prime mortgage loans have historically carried low default risk because they are usually made to high-credit quality borrowers.

(2) Alternative-A (Alt-A) mortgages: Alt-A loans are usually provided to borrowers with average or above average credit scores, and have historically required looser loan documentation requirements and allowed larger loan sizes than under agency underwriting guidelines.

(3) Option Adjustable Rate Mortgages (Option ARMs): Option ARMs are a specific hybrid type of Alt-A mortgage that has flexible repayment terms. Option ARM mortgages allow for interest-only payments and sometimes even less than interest due payments. The loan balance of an Option ARM can increase over time (negative amortization in lending jargon). Such loans are designed to start with an exceedingly below average rate of interest, usually called a ‘teaser rate,’ to attract borrowers.

(4) Subprime: Subprime mortgages are provided to borrowers with low credit ratings due to a damning or limited credit history. Subprime mortgages usually require minimal income and asset verification and carry high default risk. Lenders usually charge Subprime borrowers a higher than average interest rate.

Examples of Non-Agency REITs

Through screening I have identified several REITs that are largely invested in non-agency paper, though not necessarily exclusively or to a majority, depending on their portfolio mix. Below, listed in alphabetical order, are seven such REITs along with several vital statistics. Others exist.
Chimera Investment (NYSE:CIM)
  • Current Yield: 14.5%
  • Market Value: $4 Billion
  • Debt: $6.23 Billion
  • Price to Book Value: 1.1
  • Short Interest: 5.1%
Dynex Capital (NYSE:DX)
  • Current Yield: 11.2%
  • Market Value: $385.9 Million
  • Debt: $1.34 Billion
  • Price to Book Value: 1.0
  • Short Interest: 3.5%
Invesco Mortgage Capital (NYSE:IVR)
  • Current Yield: 17.6%
  • Market Value: $1.6 Billion
  • Debt: $5.78 Billion
  • Price to Book Value: 1.1
  • Short Interest: 5.5%
MFA Financial (NYSE:MFA)
  • Current Yield: 11.52%
  • Market Value: $2.9 Billion
  • Debt: $8.45 Billion
  • Price to Book Value: 1.0
  • Short Interest: 5%
Redwood Trust (NYSE:RWT)
  • Current Yield: 6.5%
  • Market Value: $1.2 Billion
  • Debt: $4.03 Billion
  • Price to Book Value: 1.1
  • Short Interest: 6.7%
Two Harbors Investment (NYSE:TWO)
  • Current Yield: 15.09%
  • Market Value: $739 Million
  • Debt: $2.62 Billion
  • Price to Book Value: 1.1
  • Short Interest: 3.4%
Walter Investment Management (NYSEMKT:WAC)
  • Current Yield: 11.2%
  • Market Value: $459.8 Million
  • Debt: $1.28 Billion
  • Price to Book Value: 0.8
  • Short Interest: 7%
Please note the reasonably high short positions on several of these names, even given their large sizable yields. 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.
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.

Many lower quality non-agency mortgages have already fallen apart, leaving behind a higher quality mix than existed before the onset of the real estate crisis. This does not mean that the remaining non-agency mix is secure. As interest rates rise, Alt-A and Option ARMs could become far less appealing to those borrowers. Several such mortgages are set to reset within the next year. If interest rates rise, several borrowers may not be able to handle the increased monthly payments, or not want to.
Additionally, many Option ARMs initiated in between 2002 and 2007 are already for a greater amount than the present underlying home value. This situation could get worse. Nonetheless, a diversified, core, fixed-income portfolio should probably include a strategic allocation to non-agency securities, given their ability to provide high income returns and potential price appreciation and the present uncertainty and low yield offered by government and high-credit corporate bonds.

Disclosure: I am long CIM.

Additional disclosure: 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.