3 Very Different Kinds Of Mortgage REITs

by: Philip Mause

I am writing this article because other articles and comments have revealed significant investor confusion about the mortgage real estate investment trust (REIT) sector. The sector includes a large number of companies which have very different exposures to various risks, very different amounts of leverage and very different management styles. For this reason, they perform very differently over time and are very differently affected by "risk off" dynamics, changes in interest rates, and the overall economy. Despite these important differences, I see a great deal written which lumps them together and fails to highlight these important distinctions.

All the companies discussed here - and in much more detail in earlier articles of mine - are real estate investment trusts. They generally operate under special tax rules providing them with an exemption from corporate income taxes on the condition that they pay out 90% of their taxable income as dividends to shareholders. In turn, these dividends are generally taxed as ordinary income to the shareholder. As a result, their payout ratio is much higher than the payout ratio of typical dividend stocks and they do not have as much cash, after paying dividends, to reinvest in their business. The companies discussed here are all primarily designed to hold mortgages on real estate rather than the equity in real estate. Therefore, they do not benefit as much as equity REITs from the appreciation in real estate prices.

The key difference that distinguishes the subgroups of mortgage REITs from one another is the type of mortgages they invest in. This difference has an important effect on the amount of leverage each REIT can utilize and also creates differences in performance under different market conditions among the REITs.

Agency mortgage REITs (AMREITs) invest solely or almost exclusively in mortgages or mortgage backed securities guaranteed by federal agencies - Fannie Mae, Freddie Mac, or Ginnie Mae. As a result, there is virtually no risk of an actual default on the underlying mortgages - the payment of the amount owed and the interest owed is virtually guaranteed(in the absence of a major policy change on the part of the Federal government or an actual default of the Federal government on its financial obligations). Because of the absence of a default risk, the interest rate on the assets held by AMREITs is relatively low. In order to obtain a competitive return, AMREITs utilize a great deal of leverage(between 5 and 10 to 1) and make money by earning more interest on the assets they hold than they pay on their borrowings. AMREITs tend to be adversely affected by interest rate increases although they can face problems when interest rates decline due to prepayment risks. The leading AMREIT is Annaly Capital (NYSE:NLY); it closed Friday at $16.40 and currently yields 13.9%.

Non-agency residential mortgage REITs invest in residential mortgages but primarily focus on mortgages which are not insured by one of the federal agencies. As we have all learned to our chagrin, this means that there is substantial default risk. As a result, these companies generally hold assets which generate higher levels of interest payments but use less leverage than AMREITs. There are a number of models for the companies in this sub-sector. Some companies are passive investors in mortgages and mortgage backed securities. One example is Chimera Investment (NYSE:CIM) ($2.76) (15.9%) (It should be noted that CIM holds mostly non-agency residential mortgage assets but also holds a significant amount of agency secured mortgage assets). Other companies originate or obtains mortgages or pools of mortgages for resale either individually or in a securitized form to other financial entities. One example is Redwood Trust (NYSE:RWT) ($11.28) (8.9%)(It should be noted that RWT operates as a conduit and also holds mortgage assets and that RWT holds some commercial mortgages). As noted,there are a number of "hybrid" companies which invest in a mixture of agency and non-agency mortgages and mortgage backed securities. The companies in this sector tend to be heavily impacted by both the actuality and the perception of default risk. When the market goes into extreme "risk off" mode, they can take quite a hit.

Commercial mortgage REITs invest in mortgages secured by office buildings, shopping centers, apartment buildings, industrial facilities and other commercial properties. Many of them run CLOs - pools of such mortgages broken up into tranches with the senior tranches held by conservative investors and the junior tranches retained by the originator. They make money on the CLO by earning a management fee and continuing to hold a junior tranches which will pay out only if the senior tranches are being made whole. The commercial mortgage REIT sub-sector has been an arena in which many investors have taken large losses during the downturn. Some REITs which were active prior to the 2008 Panic are trading at enormous discounts to book value - for example, NorthStar Financial (NRF) ($4.94) (10.10%). There are other commercial mortgage REITs formed since the Panic which have invested under the conditions of the "new normal" and may be more stable but may also offer a bit less upside. Starwood Properties (NYSE:STWD) ($19.05) (9.3%) falls into this category. Some of the commercial mortgage REITs wind up owning properties - often due to foreclosure - and thus are, to a limited extent, equity mortgage REITs as well.

I am not suggesting that any stock or sub-sector is a "good" or "bad" investment. It all depends on the price and the investor's objectives. AMREITs offer very high yield and some stability in equity value. Some of the other REITs bounce around a great deal and an investor who buys on dips may be able to achieve substantial price appreciation if default rates decline. It is very important, however, for any investor approaching this sector to have a thorough understanding of the company he is investing in, which type of REIT it is, and how it is likely to perform under different market conditions.

Disclosure: I am long NLY, CIM, NRF.