Which Mortgage REITs Are Most Suitable for You?

by: Parsimony Investment Research

We have been proponents of mortgage real estate investment trusts (“REITs”) due to what we believe to be a sustained low interest rate environment. But we believe new and current investors alike should continuously reevaluate their holdings and their investment thesis. Mortgage REITs are not suitable for all investors. Below we identify a number of risks that investors should keep in mind while investing in mortgage REITs.

Investors (especially conservative income investors) who are interested in mortgage REITs should invest in securities that suit their temperament when it comes to leverage, credit risk and interest rate risk. Given the proliferation of mortgage REITs over the last few years we believe investors should be able to find a REIT that is suitable for them. We have attempted to segment the largest mortgage REITs by investment thesis (see below).

Mortgage REIT Overview

Mortgage REITs take advantage of a tax status to invest in mortgage related real estate assets. REITs can invest in both physical real estate assets and real-estate related securities like mortgage backed securities (“MBS”). REITs electing the take advantage of the tax status must distribute 90% of taxable income as dividends. The primary advantage of using the REIT tax designation is that these companies do not pay state or federal corporate taxes on dividends paid to investors. Instead, the taxes are paid by the REIT equity holders (investors).

Things to Consider Before Investing in Mortgage REITs

Mortgage REITs are highly leveraged vehicles that follow a borrow short and lend long mantra, thus making the investments susceptible to rises in interest rates (much like a bank or finance company). Mortgage REITs typically buy 2 – 5 year duration securities and finance them with short term borrowing (duration will vary dramatically by REIT). To mitigate interest rate risk, REITs hedge a portion of their interest rate risk.

Importantly, a steep yield curve and stable rate environment are key drivers of their income. Investors should note, the current interest rate environment is ideal for mortgage REITs, thus investors should monitor for changes in the shape of the yield curve. Many will claim that it would be difficult for the rate environment to improve from here for mortgage REIT investors.

Mortgage REITs investors should pay close attention to the agency vs. non-agency mix and the fixed vs. floating composition of a REIT's portfolio. Agency securities have an implied guarantee from the U.S. government. Investors in the agency market tend to deploy higher leverage as agency securities are viewed as credit risk free. Non-agency securities are not guaranteed buy the U.S. government and thus carry credit risk. Click to enlarge:

Which Mortgage REIT is Best for You?

The answer depends on your risk tolerance and your view on interest rates

High Agency and Fixed Rate Mix (best for investors that believe interest rates will remain low)

  • Annaly Capital Management (NYSE:NLY)
  • American Capital Agency (NASDAQ:AGNC)

High Agency and Floating Rate Mix (best for investors concerned about rising interest rates)

  • Anworth Mortgage Asset Corp (NYSE:ANH)
  • Capstead Mortgage Corp. (NYSE:CMO)
  • Hatteras Financial Corp. (NYSE:HTS)

High Non-Agency Mix (best for more agressive investors that think the housing market is recovering)

  • MFA Financial, Inc. (NYSE:MFA)
  • Chimera Investment Corporation (NYSE:CIM)

Note: The MFA management team starting acquiring non-agency mortgages during the depth of the market crisis. We believe this was an astute play as their cost basis on these securities are likely lower than the ultimate recovery. In contrast, the CIM management team acquired non-agency securities prior to the crisis.

Parsimony's Position

In general, we think interests rates will remain low for the foreseeable future (next 12-24 months). As such, we believe mREITs offer investors an extremely compelling risk/reward profile (especially REITs with a high mix of agency securities). However, we caution investors to watch interest rates and prepayment rates very closely if invested in the space.

NLY and MFA remain our two main REIT holdings due to their strong management teams and proven ability to manage their portfolios in any interest rate environment. However, we also have a small position in AGNC.

We continue to believe that the best strategy for investing in this space is to own a portfolio of mortgage REITs to diversify your risk.

Disclosure: I am long NLY, MFA, AGNC.