Desperately Seeking Yield Through Equities: Part 3 - Non-Agency Mortgage REITs

by: Philip Mause

There a a number of important differences between agency mortgage REITs and non-agency REITs but the most important is that the non-agency mortgage REITs must deal with the risk of and the fact of default. I should also note that the world of non-agency mortgage REITS is very diverse and includes "hybrids" - REITs which include some agency backed mortgage securities and some non-agency mortgages or mortgage securities in their portfolios. This group of REITs is generally divided into commercial mortgage REITs which own mortgages on commercial properties and residential non-agency mortgage REITs which own mortgages on residential properties.

This sector tends to deal with leverage differently from agency mortgage REITs. In this sector, leverage is often concentrated in a special purpose entity (SPE) - essentially a separate body which owns mortgages or mortgage backed securities. The REIT often organizes and manages the SPE. Senior positions or loans are sold to more conservative investors and the REIT generally retains a subordinate loan or equity position in the SPE which means it gets paid only after the obligations to the more senior security holders are satisfied. Generally, the loans held by the more senior security holders are non-recourse in the sense that they can be satisfied only from the assets of the SPE. Frequently the financial statements of the SPEs are consolidated in the REITs financial statement producing an extremely confusing and misleading set of numbers.

I have written more about this sector in my Dividend Boot Camp series of articles - especially articles 2, 3, and 4. I believe I have compiled a complete list of the REITs in this sector with the exception of a few that are on their last legs. I will not list them all here but will provide a few that I think are worth analysis by careful investors. I have excluded REITs that are not paying substantial dividends because they would not be appealing to an investor "desperately seeking yield" - however sometimes such securities - if carefully analyzed - can provide excellent opportunities for investors willing to take risks. I have written some of them up in the Boot Camp series and also in Value Investing 1. For the stocks that I am presenting here, I have provided the symbol, Wednesday's closing price and the dividend yield based on the most recent dividend.

1. Residential Non-Agency Mortgage REITS

A. Chimera Investment (NYSE:CIM), (3.47), (15.90)

B. Redwood Trus t(NYSE:RWT), (14.96), (6.7)

C. Invesco Mortgage (NYSE:IVR), (21.02), (17.5)

2. Commercial Mortgage REITs

A. NorthStar Financial (NRF), (3,90), (10.20)

B. Starwood Properties (NYSE:STWD), (20.06), (8.7)

C. CreXus Financial (NYSE:CXS), (10.26), (8.9)

D. Appollo Commercial (NYSE:ARI), (15.91), (10.00)

E. PMC Commercial (PCC), (8.48), (7.5)

As a general matter, this group has been hammered in the "risk off" trade atmosphere that has beset the market over the past 6 weeks and I think some bargains are opening up. These companies are extremely diverse in terms of structure, leverage, asset mix, management quality and style and history. Each one has to be evaluated individually. There are important differences in vintage of assets - loans made shortly before the Panic of 2008 were often based on unrealistic asset valuations. Some of these companies have had lender problems and some of them haven't.

CIM is a hybrid managed by the folks who run Annaly (NYSE:NLY) and who seem to have survived some nasty turns in the market over the years. It has bought some troubled mortgages at a discount after the Panic but, arguably, not at a big enough discount. It has recently taken a nasty hit in the market which may be overdone.

RWT has been in and is returning to the mortgage conduit business. It puts out the Redwood Review which is probably the best description of the business and financial status of a company in this sector.

IVR is a kind of super-hybrid, go anywhere, do anything company that is flexible in strategy and looks for attractive opportunities wherever they develop. It seems to have solid management and may be attractive at this price.

NRF has had issues with its lender that are now resolved on reasonable terms. It completed a secondary offering at 4.25 in May so that a buyer now is getting the benefit of the cash raised in that offering at a discount. Its management is generally well regarded and, at this price, it offers considerable potential for appreciation.

STWD is a post-Panic entity, buying mortgages in a much more conservative atmosphere and thus probably not facing the kinds of default risks that beset some of the others. On the other hand, there is not much of a track record.

CXS turned down a buyout offer at $14 a share in March and recently acquired a large portfolio of mortgages. It probably has some unhappy shareholders but at this price may be attractive.

ARI seems to have a more simple balance sheet than some of the others and has been active in the TALF program.

PCC is relatively small, sells at a big discount to book value and is active in the SBA loan market.

These are not the kinds of stocks that tend to do well when the possibility of defaults by Greece, Ireland, Portugal, and ...the United States of America are being discussed constantly in the news. The very word "default" probably takes a few points off of each of these stocks every time it is uttered on CNN because of the bad memories it conjures up.

On the other hand, an investor who puts a limited portion of his portfolio into a mix of these stocks will be paid fairly nicely to wait. Investors should devote some time to analyzing each of these individually and should try to take limited positions in the ones determined to be attractive on the dips that the market is likely to provide over the next several months.

Disclosure: I am long CIM, IVR, NRF, CXS.

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