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Mortgage Real Estate Investment Trusts (MREITs) have the highest yields of any stock grouping available today. As might be expected in today’s yield-starved environment, this group receives a lot of attention. There are many informative articles available on Seeking Alpha and elsewhere on MREITs, but an investor who is not familiar with this asset class may have some difficulty understanding them. If you identify with this thought, this article is for you.

I will begin by providing several links to some excellent resources that I have located that explain what MREITs are, and the concepts behind this business model. Further, these articles are mercifully brief. Next, I will list several SA authors that have addressed MREITs in recent articles, as a sampling of what is available on SA. After that background, I will examine in some detail two MREITs that I own, Annaly Capital Management (NYSE:NLY) and MFA Financial (NYSE:MFA). Specifically, I will present five years of history on prices, dividends, and yields, which after all are what governs the return. I will also list historical values for debt/equity ratios and interest rate spreads, as taken from the 10Q’s and 10K’s. These two items are key metrics in evaluating MREITs, along with book value, as you will learn from the background materials. Finally, I will conclude by offering my own views on the advisability of investing in MREITs, and I will describe how I address the risks these types of high-yield entities introduce into my portfolio.

All of these introductory articles are very brief, and can be read in a minute or two. The first article to be offered is from Tickerspy, entitled “Mortgage REITs: A Look Inside Tickerspy’s Highest Yielding Segment”. It provides an excellent synopsis on MREITs. The second article is from Forbes, entitled “The Case For Mortgage REITs”, which is self-explanatory, as per the title. The third article, from Common Sense Investing, is entitled “Common Sense Formula For Taking Profits On Your Mortgage REIT Investments”. While I am more of a “grit your teeth and hold” investor, if you want to try timing your exit from the sector, this article presents an interesting approach.

To summarize and supplement the introductory articles:

  • Mortgage REITs don’t own real estate like regular REITs, they own mortgages on real estate and/or mortgage-backed securities.

  • Profitability is impacted by the difference between the short-term rates the firms must pay for funds and the rates on the mortgages and mortgage-backed securities they hold. This difference is referred to as the interest rate spread.

  • These businesses utilize leverage to improve returns. The extent to which leverage is employed is indicated by the debt/equity (D/E) ratio.

  • The book value of these firms is basically the value of the mortgages/ mortgage-backed securities they hold, less liabilities. Book values for MREITs will decline if interest rates rise, and are revised for each reporting period as holdings are marked to market. This is different than the typical corporation, which bases book value on historical, amortized cost accounting.

  • Some MREITs concentrate on mortgage securities backed by government agencies, and are referred to as Agency REITs. Non-Agency REITs concentrate on mortgages that are not government guaranteed. Hybrid REITs have both.

  • The primary risk these firms face is interest rate risk. Non-agency mortgage instruments are also subject to default risk.

  • The firms may hold floating-rate securities as well as fixed-rate, and may employ various hedging strategies to address interest rate risk.

Several examples of how interest rate changes can adversely affect MREITs are: Rising short-term rates will increase the cost of funds; rising long-term rates will lower book values, will increase leverage, and will limit the ability to raise capital through secondary offerings; and finally, falling or flat but very low long-term rates will result in higher-rate mortgages being replaced by lower-rate mortgages, due to refinancing. The falling interest rate environment that has prevailed since 2008 has been a benevolent one for MREITs. Book values have increased, secondary offerings have been placed, short-term funding costs have been low, and with the nation’s economic problems, refinancings have been limited. But now, with rates about as low as they can go, the beneficial effects of rates moving lower are pretty much over, while refinancings are slowly reducing the aggregate interest rates on assets held.

Now, let’s move on to some of the Seeking Alpha articles I mentioned. In lieu of generating a long list of articles, I will list a few authors and note one or two articles to review. You can get to the articles through one of two paths; go to an author’s profile page and list all articles for that author, or simply enter the stock symbol for a given MREIT stock in the search box and let SA bring up the articles for that stock. Note that there are many additional articles by these and other authors besides those listed, which are just a sampling. (Note: links to the authors' profiles are provided with the author names; links to specific articles, when cited, are provided in the titles.)

As can be seen, there is a lot of interest in MREITs, and many differing opinions. Now that you have some background, let’s consider the two MREITs I own in detail.

First, consider Annaly Capital Management. Founded in 1997, it is the largest MREIT, with a $15 billion market cap. Annaly primarily deals in agency-backed mortgage securities. The recent market price has been in the $16.00 to $16.50 range, and the latest mark-to-market book value per share is $16.44, so it is basically trading at book value. The most recent dividend of $.57/share translates to an annualized yield of nearly 14%.

Annaly has consistently stated that it seeks to utilize leverage to an extent such that the debt to equity (D/E) ratio target is 8 to 12. Yet, in its most recent quarterly 10Q, for the period ending 09/30/2011, the company states that the D/E ratio is only 5.5. This information seems to imply that management is positioning the firm for tougher times ahead, and to the extent that this implies a conservative approach, is comforting to me as an investor. The 10Q also states that the interest rate spread is currently 2.08%, a very beneficial spread for a MREIT.

Less comforting, however, is the fact that the prior quarter reported the spread as 2.45%, indicating that the trend is not favorable. As an aside, an S&P report on Annaly released on 01/06/2012 predicts the spread will drop to 1.84% in 2012 due to refinancings. To try to get a clearer perspective on these metrics and what they may imply, I have compiled data for the previous five years, as presented in the table below. For the day before each ex-dividend date, I show the closing price, the dividend amount, and the annualized yield as calculated. I note the five-year lowest and highest dividends, and also the five-year lowest and highest yields, considering only these dates. Unrelated to ex-dividend dates, I also note the lowest price and the highest price ever reached (even if intraday) over the time period, the date these extremes occurred, the dividend rate in effect, and a calculated annualized yield. Finally, I show for each quarter-end the interest rate spread, as reported, and for each year-end, the D/E ratio, as reported.

Even though this period encompasses the recent financial crisis, keep in mind that this time-frame overall was very favorable for the MREIT business model. As such, the readings are not necessarily indicative of what the next five years might bring. (Note: current and historical 10Q and 10K reports are available from Annaly's website. See INVESTOR RELATIONS, SEC Filings. Here is a link.)

Click to enlarge:

While prices have shown some volatility, and dividends have been variable, the data reveals that most of the time an investor purchasing Annaly during this time-frame has enjoyed a double-digit yield. The data also reveals that the D/E ratio has not been above 8 since 2007, so perhaps the current 5.5 D/E ratio is not as much of a move towards a more conservative stance as it might have seemed. Further, we can observe that the interest rate spread has been above 2.00% most of the time since the middle of 2008, which confirms that the environment since then to the present has been very favorable. The latest ex-dividend date was 12/27/2011, so there is no rush to buy just now. Annaly will report earnings on 01/30/2012, at which time new values for the key metrics will become available. Based on all of the preceding, I believe caution is in order. Other than that, I will defer my conclusions as to what I plan to do, and what I would recommend, to the end of this article.

Next, consider MFA Financial (MFA). This is also a sizeable company, with a market cap of $2.5 billion. Established in 1998, MFA invests in both Agency and Non-Agency mortgage-backed securities. MFA has recently traded in the range $6.70 to $7.20, and book value for the most recent filing period ending 09/30/2011 was $7.43, so it is trading below book value. The most recent dividend of $.25/share translates to an annualized yield in excess of 14%. MFA states in its filings that (unlike Annaly) it does not target a specific D/E ratio range.

The most recent 10Q, for the period ending 09/30/11, reported a D/E ratio of 3.4, indicating MFA is less leveraged than Annaly. The interest rate spread last reported was 2.83%, down a little from the prior quarter’s 3.05%, but still better than Annaly. Again, a clearer picture should emerge if we consider the same data for the previous five years for MFA as was examined for Annaly. The data is presented below. (Note: current and historical 10Q and 10K reports are available from MFA's website. See Investor Relations, SEC Filings. Here is a link.)

Click to enlarge:

Similar to Annaly, most of the time MFA buyers have enjoyed double-digit yields these past five years. The D/E ratio has declined considerably from the earlier years, and the interest rate spread has been greater than 2.00% since the middle of 2009. The last ex-dividend date was 12/28/2012, and the next earnings reporting date is 02/13/2012. Similar to Annaly, there is no rush to buy, and waiting for new metrics to become available might be advisable before taking any action.

So what to do? Before I present my opinions, in the interest of full disclosure, note that I am not a financial professional, nor am I certified in any way as a financial advisor. I am an independent, small investor managing my own portfolio.

Every instinct I possess as a dividend investor tells me to beware anytime yields move into double digits. Yet, I can see that over the last four years, at least, these companies paid out substantial sums to shareholders. As for the outlook at this point, I concur that the window of favorable conditions is closing, but it is closing so slowly that I believe there is another year or more to go before it slams shut, if then.

So, as the article title asks, what’s the catch? The catch is that there are many risks. The MREIT business model has been able to prosper in the declining interest rate environment we have seen since 2008, but rates are about as low as they can go, so this force is spent. The Fed has pretty much committed to short-term rates staying low for another year, so that is a positive. Further, although the Fed doesn’t control long-term rates directly, it influences them, and based on recent experience, it appears long-term rates will also stay low for another year or so. It is true that refinancing activity will slowly erode the interest rate spread if long-term rates stay low, but this is a very gradual process, and may in fact be slowing down as the obstacles preventing many homeowners from refinancing are formidable. Plus, book values will hold up well if long-term rates don’t rise. After digesting all of the above, here is what I’m going to do:

  • Continue to hold my position in Annaly, which represents about half of 1% of the portfolio. Purchase an additional increment of Annaly upon a market decline which takes the price substantially below book value. Purchase further increments upon further declines, with a maximum holdings limit of 1% of the portfolio. In the event Annaly rises above 18 or so (not expected), either sell out or sell covered calls.

  • Continue to hold my position in MFA, which represents about a third of 1% of the portfolio. Similar to Annaly, only add to the position upon significant declines, with a limit of approximately double what is owned now, to about half of 1% of the portfolio. Employ the same selling / covered call strategy as for Annaly.

  • Consider adding a third MREIT upon a market decline, again with a maximum holdings limit of about half of 1% of the portfolio. Do a similar analysis as was done for Annaly and MFA on several candidates, to determine which one to buy.

  • The overall limit of MREIT holdings will thus be about 2% of the portfolio.

  • I don’t believe these companies will go bankrupt, even if a severely adverse environment arises. I am prepared to hold through all adverse situations, even if dividends are suspended. Only if bankruptcy appears certain will I sell, to claim the loss.

  • I believe these stocks should be held in taxable accounts, so if a loss occurs, it can be claimed for tax purposes. That outweighs (for me, at least) the fact that the dividends are not qualified and are thus subject to ordinary income tax rates.

This strategy benefits from the high yields of MREITs, yet recognizes that there is indeed a “catch”, such that a very cautious strategy is called for.

What should an investor do if he/she currently has no MREIT holdings? Ideally, go back about three years and buy like mad. Unfortunately, that option is not available. Much depends on the risk tolerance a person has. I would recommend that a maximum amount of funds to be allocated to MREITs be defined in advance, and this allocation needs to be set with the realization that a large loss is possible.

Next, depending upon how much is earmarked, a short list of candidates should be identified. Track earnings reporting dates on these firms, and upon release, review the results to make sure the subject should remain on the buy list. Before buying, track ex-dividend dates, and initiate positions within a time window of two to three weeks prior. I prefer being paid sooner (after buying) rather than later. Start small, and don’t pay more than book value. Once in, hold off on adding more until a market decline provides an opportunity. Continue to average down until the full allocation is achieved.

I would recommend that you not start out in the first place if a decline is going to cause you to sell out. With these volatile stocks, a major drop is possible. Decide in advance whether you will exit based upon timing signals or a percentage decline, or will hold on if an unfavorable environment develops, awaiting a turn-around and a resumption of dividend flows (keep in mind it could take years).

Note: Additional data sources (besides those linked above) that were referenced in compiling this article were MicroSoft Money, for book values, Think or Swim Charts, for historical prices, and TD Ameritrade Charts, with Comparisons and Events checked, for historical dividend dates and amounts. (An account with TD Ameritrade is required for access to Think or Swim, TD Ameritrade Charts.)

Source: Mortgage REITs And Double-Digit Yields: What's The Catch?

Additional disclosure: Links added as suggested. This article goes back to basics, and should be helpful for investors unfamiliar with Mortgage REITs who are intrigued by the huge dividend yields, to become aware of the risks these companies can present. Yet the article doesn't say stay totally away, but allows for a managed speculation that if followed as outlined will not cause too much grief even if things don't work out favorably.