Mortgage REITs own the mortgages on real estate rather than the property. Some mREITs concentrate on commercial mortgages and others concentrate on residential property mortgages.
Agency mortgages are backed by federal agencies, while non-agency debt has no such backing. Three well-known agency mREITs are Annaly Capital Management, Inc (NLY), American Capital Agency Corp (AGNC) and Hatteras Financial Corp (HTS). Three well-known non-agency mREITs are Chimera Investment Management (CIM), MFA Financial (MFA) and Invesco Mortgage Capital (IVR), though these companies also can and do buy large positions in agency paper.
Most of these mREITs performed poorly during June and July, as the debt ceiling debate generated risk to the agency paper and housing in total. Moreover, several of the highly leveraged mREITs have been utilizing hedging strategies and holding ARM paper in order to counteract anticipated rising interest rates. Subsequently, the U.S. credit downgrading, interest rate fluctuations and further real estate weakness have pushed and pulled at the MBS paper value that these mREITs hold. This could mean that some mREITs may lose money on short-term hedging strategies (like an insurance policy that was never triggered).
Most mortgage REITs produce high yield returns by leveraging a spread. The spread is the profit margin the REIT can achieve between the rate on the money they borrow and the rate paid by the mortgage paper they hold. For example, if a company can borrow at 3% and buy paper that yields 5%, the spread is 2%. The level of leverage used by the REIT then multiplies that spread payout. A major risk for mortgage REITs has been that the spreads will get hurt due to increasing interest rates decreasing the spreads due to a raise in borrowing costs. Lately, interest rates have actually been decreasing, however.
About two weeks ago, Ben Bernanke added some greater certainty to the interest rate question. Prior to then, the Federal Reserve's comment as to the interest rate was that it would be kept low for an extended period, with no real explanation of what that meant. As a result, and especially due to the end of QE2, many people have estimated that the Federal Reserve would soon facilitate a rising rate. But this month, the Federal Reserve Board explained that it would keep the Federal Funds Rate near zero through mid-2013.
This news was good for Mortgage REIT spreads by ensuring that the borrowing rates will stay under pressure for the next few years. The uncertainty that the Fed eliminated is of special note to these mREITs as it was one of their greater risks. On the strength of that, on the day the Federal Reserve defined an extended period the above-mentioned equities were all up about 10%.
On Friday, Ben Bernanke is scheduled to make some remarks, just about a year after he made his first hint at what has now come to be known as QE2. It appears that the Federal Reserve has only so many weapons in its arsenal, and that this particular board is hell-bent on keeping interest rates low in an attempt to generate more investment in equities and other assets than cash. When Mr. Bernanke speaks on Friday, like most prior speeches, it should bode well for the mREIT 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.
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.
Disclosure: I am long NLY, CIM.