Agency Mortgage REITs: Understanding The Risks

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 |  Includes: AGNC, ANH, CMO, CYS, HTS, NLY
by: Philip Mause

In an investment market starved for yield, the double digit yields of agency mortgage real estate investment trusts (AMREITs) are extremely attractive. There has been a great deal of confusion about this sector and it is important for investors to understand exactly what these companies do and what risks are involved.

Below is a list of the companies generally considered to constitute this sector. There is some room for debate as to this list because there are "hybrid" mortgage REITs which invest in some agency mortgage backed securities as well as other assets. For the purposes of this piece, I have excluded hybrids. In each case, I have included the symbol, Friday's closing price, and the annual yield based on the most recent dividend.

Company

Symbol

Jan. 6 Closing Price

Annual Yield

Annaly Capital

NLY

16.06

14.2

American Capital

AGNC

28.37

19.9

Hatteras Financial

HTS

26.43

13.7

Anworth Mortgage

ANH

6.26

13.5

Capstead Mortgage

CMO

12.52

14

Cypress Strategy

CYS

13.28

15.3

Click to enlarge

First of all, AMREITs are real estate investment trusts; they receive preferential tax treatment in exchange for a requirement that they pay out 90% of earnings as dividends. The dividends are generally taxed as ordinary income to shareholders. For shareholders using IRAs or other tax advantaged accounts, this is not a disadvantage but for shareholders using a taxable account, a higher tax liability is involved.

Secondly, unlike equity REITS, AMREITs invest in debt instruments or securities backed by debt instruments rather than real estate itself. There is little or no potential for appreciation in value due to a rising real estate market or increasing rental income.

Thirdly, AMREITs invest exclusively or virtually exclusively in securities (residential pass through certificates or collateralized mortgage obligations) for which principal and interest payments are guaranteed by a United States government agency or a United States government sponsored agency - generally Fannie Mae, Freddie Mac, or Ginnie Mae. For this reason, default risk is minimal or non-existent.

Finally, all of these companies employ considerable leverage - usually at a ratio of between 5 and 10 times net asset value, and their earnings are largely attributable to the "spread" between the interest earned on the pool of agency backed mortgage securities owned and the interest paid on the debt creating the leverage.

These features create some unique risks and benefits and make it very difficult to compare these companies with other stocks. For this reason, when one or more of these companies is compared with other "high yielding" stocks or even with other REITs, the metrics of comparison can be very misleading. In a real sense, these companies are probably more comparable to bond funds in that they invest exclusively in debt instruments.

There are essentially four risks associated with these companies. These risks can result in lower dividends, a lower book value, and/or a lower stock price. I am assuming for the purpose of this article that "default risk" is not significant because of the guarantees by government agencies but there is a remote possibility that Congress could alter the agency mortgage guarantee system or that the United States Government could reach such a level of dysfunction that the debt ceiling would not be increased and there would be a default on its obligations.

More realistically, the first risk is the one that everyone focused on a year ago - interest rate risk. If interest rates increase, AMREITs will have to pay higher interest on the debt used to create leverage. In addition, the value of their securities may decline. Finally, the stock price may decline because, in a world of rising interest rates, more alternate opportunities for high yield may materialize. At this time, interest rate risk is minimal because the Fed is likely to keep rates low for a considerable time in light of the Eurozone problems, recent appreciation of the dollar, and the still sluggish domestic economy.

The second risk is prepayment risk. This involves the faster than anticipated payment of principal on the mortgages which make up the securities owned by AMREITs. It is generally due to refinancing and can occur when current rates are lower than the rates which existed when mortgages were originally entered into. Recent months have seen increased concern about this issue. Prepayment tends to remove relatively high interest rate mortgages from the pool and requires that money be redeployed into the market at lower yield. Oddly enough, the troubled real estate market has probably resulted in lower prepayment levels than the interest rate environment would suggest because homeowners who are "underwater" with their mortgages cannot refinance and are stuck with their existing high interest rate obligations. Of course, a government program to assist homeowners in refinancing would tend to increase this risk. AMREITs have dealt with this risk in a variety of ways - buying pools of mortgages overweighted with adjustable rate mortgages and short term mortgages and hedging - but it is a real concern in the sector.

The third risk is leverage risk. With a relatively high level of leverage, any decline in the value of the assets held by the AMREIT is amplified by leverage. If the leverage is 5 to 1, a 10% decline in the value of the total net assets could result in a 50% decline in book or net asset value. Additionally, there is always the possiblity that, in a financial crisis, lenders might freeze up and refuse to provide financing(most AMREITs borrow on a relatively short term basis) and the AMREIT would be required to liquidate part of its portfolio at the same time that other participants in the market are liquidating leading to a decline in pricing of portfolio assets. This does not appear to have occurred during the Panic of 2008 although there may have been some anticipation of this in early 2008 resulting in the decline in the stock prices of companies in this sector. NLY's price declined precipitously at around the time of the Bear Stearns debacle.

Finally, there is regulatory risk. Currently, the big concern is that the SEC will take action subjecting companies in the sector to the leverage limitations in the 1940 applicable to investment companies. This would drastically reduce leverage to a 2 to 1 level and require the sell off of assets and would reduce earnings in the sector dramatically. Because of the negative effects such action would have on the mortgage market and because the AMREIT sector actually weathered the 2008-09 storm relatively well, I think it is unlikely that the SEC will take such action but it is worth keeping an eye on this issue.

The AMREITs are run by some very savvy managers who are constantly monitoring these risks and have developed sophisticated strategies to minimize them. The individual companies in the sector follow different strategies for minimizing the impact of these risks and, for this reason, an investor is well advised to diversify within the sector with an overweighting in favor of NLY(by far the largest in the group and also the company with the longest track record). I still believe that investors will do better in the long run with a portfolio of dividend paying stocks - especially if Congress extends the preferential tax treatment for dividends(senior citizens should really try to get the both parties to focus on this issue). After all, AMREITs will be very unlikely to be able to sustain consistently increasing their dividends(in recent months, some have had dividend declines). On the other hand, AMREITs can be an important component in a yield oriented portfolio as long as the investor is aware of the risks outlined above. I hope to go into more detail on the individual companies in the sector in future articles.

Disclosure: I am long NLY, HTS, AGNC, CMO, ANH.