9 High-Yield Mortgage REITs Now Trading Near Or 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, making money off the spread (or difference) between the two rates multiplied by the amount of leverage used. Because of this leverage, mREITs often have debt that is a multiple of 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 adjusting MBS payments, and the others do not adjust at all. 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.

In 2011, mREITs have faced the risk of a defaulting government, regulatory changes, defaulting non-agency mortgage holders and higher interest rates, among 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 continued to underperform the market. Moreover, this underperformance existed among most financials, and not just mREITs.

As a result, several mREITs yielding in the double digits are now trading at or below book value, . Below are the current price to book values of 9 mREITs [AGNC, NLY, ANH, CMO, CIM, HTS, IVR, MFA and TWO] that currently yield between a respectable thirteen and twenty percent.

These high yields are not without risks. Several depreciated considerably during 2011 some of these mREITs are now trading at more than a 10% discount to their book values. This may indicate that their MBS values will come down this quarter and that the company has used cash to pay dividends, lowering the book, but such a significant discount to high yield mortgage paper could also mark a market over-reaction. These mREITs will re-release book valuations with their Q4 earnings in four to six weeks. Mortgage 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.

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. At their current values and payouts, these mREITs offer a higher yield option than almost any other equity or fixed income instrument.

: 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.