Mortgage REITs Suffer a Significant 1-Month Drop, With Risk Still on the Horizon

by: Zvi Bar
Investors looking for higher yielding equities to supplement a fixed income portfolio often consider agency mortgage REITs. Most REITs are equity REITs that own and/or manage properties. Mortgage REITs, just own the mortgages on real estate rather than the property. Some mortgage REITs concentrate on commercial mortgages, while others concentrate on residential property mortgages. Agency mortgages are backed by federal agencies, while non-agency debt has no such backing.
Most of these mREITs have recently performed poorly over the last month and into the recent steel sell-off, largely due to the debt ceiling debate and further real estate weakness risk. Now, the downgrade of U.S. debt may affect these mREITs by altering their credit ratings too. Moreover, should the downgrade act as a catalyst for higher interest rates, that may weaken the spreads that these mREITs can obtain between their borrowing costs and MBS return, especially if defaults increase.

A few mREITs are now yielding around 20%. Though using reasonably high leverage, agency REITs are often viewed as relatively safe investments. Below are seven mREITs that currently yield 14.9% to 20.5% and their performance over the last month:
American Capital Agency Corp. (NASDAQ:AGNC)
  • Current Yield: 19.9%
  • 1 Month Performance: -6.33%
Annaly Capital Management, Inc (NYSE:NLY)
  • Current Yield: 14.9%
  • 1 Month Performance: -4.57%
Capstead Mortgage Corp (NYSE:CMO)
  • Current Yield: 15.4%
  • 1 Month Performance: -9.21%
Chimera Investment Corporation (NYSE:CIM)
  • Current Yield: 17.4%
  • 1 Month Performance: -13.5%
Cypress Sharpridge Investments (NYSE:CYS)
  • Current Yield: 18%
  • 1 Month Performance: -3.6%
Invesco Mortgage Capital, Inc. (NYSE:IVR)
  • Current Yield: 20.5%
  • 1 Month Performance: -15.14%
Two Harbors Investment Corp (NYSE:TWO)
  • Current Yield: 16.7%
  • 1 Month Performance: -13.71%
Over the last month, all seven of the above-mentioned mREITs are down and four are down over 9%, or over half of their annual yield before taxes. IVR is currently the highest yielding listed mREIT, paying an annualized 20.5%, but it also performing the poorest over the last month, losing over 15% or about 9 months worth of its current annual dividend before taxes. CIM and TWO also depreciated by an amount relatively comparable to 3/4 of of their annual yield. See the 1-month performance chart of the group below. Click to enlarge:

These REITs are also well known for their secondary offerings, and some individuals are now speculating on coming offerings in addition to possible interest rate changes potentially affecting their spread-margins. Additionally, it is likely that some of these mREITs will announce lower book values in the coming weeks, though NLY did recently report an improved book value over the last quarter.

These mREITs are likely to remain volatile while the U.S. rating downgrade causes income investors to reorganize and the European sovereign issues resolve. This coming week may be especially volatile as the market reacts to the U.S. debt downgrade and potential subsequent downgrades by the other rating agencies.
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 are taxed as ordinary income, many investors appreciate holding them in tax-sheltered accounts, such as an IRA.

Disclosure: I am long CIM, NLY.

Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.