7 High-Yield mREITs Now Trading Below Book Value

by: Zvi Bar

Mortgage REITs react to changing interest rates and spreads. Most mREITs obtain lofty yields through leverage. They borrow money at one rate and buy mortgage paper (MBS) at a higher rate, and make money off the spread (or difference) between the two rates multiplied by the amount of leverage used by mREITs. Because of this leverage, mREITs usually have far more debt than their market value.

Rising interest rates will largely reduce spreads and values. This is not always the case, but usually is for several reasons, including that a rate increase usually affects borrowing costs more than it raises required MBS payments. Each mREIT has a proprietary allocation of fixed and adjustable rate (ARM) mortgage securities. Changes in rates will affect the value of these securities and the spreads these REITs can make off of them. Other differences exist in portfolio composition, including agency backing or non-agency paper, and the rating/quality of non-agency paper, if any.

Recently, mREITs have faced the risk of a defaulting government (a low risk), defaulting mortgage holders (a higher risk) and higher interest rates (a seemingly inevitable risk), among several others. This has resulted in generally poor performance by most mREITs over the last several weeks. Many of these mREITs began depreciating prior to the broader recent market sell-off, and most mREITs had a very poor July.

As a result, several mREITs are now trading below book value even though most, but not all, were slightly above book value just a few weeks ago. Below are the current price to book values of seven mREITs [(NYSE:IVR), (NYSE:TWO), (NYSE:ANH), (NYSE:CMO), (NYSE:CIM), (NYSE:HTS), (NYSE:MFA)] that currently yield between a respectable 14.8% and a whopping 22.89%:

Several of these mREITs are now trading at more than a 10% discount to their book values. This may indicate that these values will come down, but such a significant discount to mortgage paper could also mean that a market over-reaction has hit the industry.

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.

REITs are also well known for having secondary offerings, which could lower book value where the funds are not used to acquire productive, appreciating assets. Nonetheless, at the current prices, these mREITs are offering a higher yield option than almost any other equity or fixed income instrument out there.

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. I am long CIM.

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