Current Price to Book and Agency Positions for 7 mREITs Yielding Over 12%

by: Zvi Bar

There are many REITs that manage portfolios of securitized mortgages. These REITs purchase mortgage paper as an investment and/or to re-securitize and sell the paper to another entity. Several of these mortgage REITs that held large positions in non-agency paper performed very poorly through and following the real estate collapse. Nonetheless, 2010 was a fairly stable year for the group and the group offers some of the highest yields one can find in the open market. Yield hungry investors must be salivating at the concept of payouts that are nearing 20% on some of these institutions.

Some mortgages are agency backed, which means that the mortgages were issued and/or guaranteed by a quasi-government agency (Fannie Mae and Freddie Mac). Such mortgages are considered virtually risk free, because these agencies are supposed 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 default continues for several months.

Mortgages that are backed by these agencies carry the least default risk because of that agency guarantee, but that risk also means that these mortgages carry the lowest yield. As a result, most REITs that specialize in agency backed mortgage securities use a high level of leverage to increase the yield. In so doing, these companies are substituting default risk for leveraged interest rate risk.

The largest and most well known REIT within this space is Annaly Capital Management, Inc. (NYSE:NLY), though American Capital Agency Corp. (NASDAQ:AGNC) and others hold agency portfolios and have high leverage profiles. Differences do exist amongst REITs housing agency-backed mortgages, such as the level of fixed versus adjustable rate mortgages, leverage rates and methods used, if any, to hedge interest rate risk. Annaly actually handled the real estate collapse rather well, largely due to that government guarantee.

The poster-child for non-agency mortgage REITs is likely Chimera Investment Corporation (NYSE:CIM), since Annaly spun-off the company in late 2007 in order to separate those non-agency securities from Annaly’s agency-backed portfolio. Chimera did not handle the collapse well because there was no guarantee. Annaly manages Chimera’s portfolio, which is primarily composed of non-agency mortgages and CDOs. Chimera sells mortgages it securitized and keeps those Annaly tells it to keep, probably based on a greater likelihood of continued payments and/or paper that represents more stable underlying real estate (though still a risky asset). Several other mortgage REITs implement a similar strategy to Chimera.

Below are the current yields, positions held in agency paper and price to book values for seven of the larger mortgage REITs:

Some of these REITs achieve their lofty yield through the implementation of significant leverage. This leverage makes them more sensitive to changes in the market, positive or negative, especially where not hedged. Some current leverage information for these REITs can be found here. Additionally, most of these REITs have reasonably high short positions, indicating several investors perceive continued problems within this asset class.

In closing, should you be interested in investing broadly in this sector, iShares has created an Exchange Traded Fund that tracks the performance of the index of residential and commercial mortgage real estate, mortgage finance and savings associations sectors (NYSEARCA:REM). Most of the listed REITs are within REM’s top holdings.

Disclosure: I am long NLY, CIM.