Seeking Alpha
Long only, value, special situations, long-term horizon
Profile| Send Message|
( followers)  
There are many REITs that manage portfolios of securitized mortgages. These companies buy the mortgage paper as an investment, or in order to re-securitize them and sell them to another REIT or some other entity that is investing in real estate loans. 2010 was a fairly stable year for the group, which offers some of the highest yields one can find in the market, but significant risks and fears to overshadow these mortgage REITs.
Mortgage REIT Risk on the Horizon

One concern within the real estate market is that another large wave of adjustable rate mortgages (ARMs) are scheduled to reset in 2012, and that higher interest rates, underlying real estate valuations and debtor quality will further push down real estate values and that foreclosures shall riddle these securitized products with holes. Mortgage REITs are generally expected to have lower spreads as rates increase, and increased rates are anticipated.
Another risk is borne by the agency mortgage market. Agency mortgages are considered virtually risk free, because U.S. agencies have guaranteed to step-in and make payments to the lender on behalf of the non-paying borrower that they backed. These agencies can also choose to buy-out the mortgage, and they often do exactly that after a borrower’s continued default for several months. Three well-known agency mREITs are Annaly Capital Management, Inc (NYSE:NLY), American Capital Agency Corp (NASDAQ:AGNC) and Hatteras Financial Corp(NYSE:HTS). There is a risk that this whole market may become altered by future regulations to and / or agency interaction in mortgages.

Non-agency mortgages have more specific risk. Three well-known non-agency mREITs are Chimera Investment Management (NYSE:CIM), MFA Financial (NYSE:MFA) and Redwood Trust (NYSE:RWT), though these companies also can and do buy large positions in agency paper. Without an agency backing, defaulting mortgages mean no payments and a considerably reduced value. Some non-agency paper is priced to assume significant default likelihood upon a rate increase and/or continued depreciating prices.

Other risks certainly affect these businesses, such as tax law as applied to REIT dividends and personal income tax rates, among others.
Recent Market Activity Shows Increased Preference For Agency Paper

The past year was a relatively stable year for most mREITS, with most paying high dividends and also showing mild appreciation. All the above-mentioned names, regardless of their agency affiliation, performed within less than 10% of the performance of the broader industry as shown by the iShares FTSE NAREIT Mortgage REITs Index ETF (NYSEARCA:REM).
This relative stability has begun to diverge in the nearer term. This can be shown in the 3-month chart, below, where the performance of the agency merits all outperform the index and the non-agency merits
Click to enlarge
Only the share price (not counting dividends paid/owed) of NLY and AGNCY were positive for the period. While HTS depreciated, it did outperform the index as shown by REM, which itself outperformed the three non-agency mREITs.
In the 1-month term, this divergence in performance is also noticeable, as is shown in the chart below.
Click to enlarge

Over the past month only the agency mREITs’ shares had positive returns, while the index and the three non-agency-buying mREITs all had negative returns.
This divergence in performance should not be terribly unexpected. U.S. property values continue to depreciate, and coming defaults and foreclosures appear inevitable. Much of this already was priced in and all of these REITS are priced relatively close to book value, though valuing this paper can be a difficult art. Nonetheless, this difference appears to highlight a significant expectation that real estate will sustain a second move downward in the near-term.
These mREITs offer significant yield and some real and understandable property-related risks. Exposure to either agency or non-agency mREITs should be limited to a reasonable percentage of a portfolio. Continued negative pressures within the non-agency segment could push their REITs below book value, where a fiduciary may again consider these options both for both value (appreciation) and income.

Disclosure: I am long NLY, CIM.

Additional disclosure: Yield is but one factor in choosing a proper investment. Investments should be considered on their own merit and relative to the total portfolio of investments.

Source: Recent Agency mREIT Outperformance Indicates Increased Fear of Continued Defaults