In this low-interest rate environment, many investors are looking for higher-yielding equities to include in their fixed income and greater portfolios. One popular option offering dividends that are significantly above average is the agency mortgage REIT.
Agency mortgage REITs possess very interesting advantages and risks that make them, in many ways, different from most other REITs or equities. Mortgage REITs own mortgages on real estate assets rather than the assets themselves. Some mortgage REITs concentrate on commercial property mortgages, while others concentrate on residential property mortgages.
Within the world of residential mortgage REITs, there are two primary subdivisions: those that own mortgages insured by federal agencies and those that own mortgages without agency insurance. Agency mortgage REITs are supposed to have portfolios made up principally of mortgages insured by the federal agencies Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC) and/or Ginnie Mae. The best known and largest agency mortgage REIT, or mortgage REIT of any sub-class, is Annaly Capital Management, Inc. (NLY). Annaly is also one of the oldest publicly traded mortgage REITs.
These government agencies make mortgages and then issue a mortgage backed security (MBS). An agency MBS, as opposed to an MBS issued by a non-agency lender, comes with an agency guarantee and an implied U.S. government guarantee. These federal agencies' implied or quasi-government guarantees have, so far, been proven virtually as solid as any paper issued directly by the Treasury, but they are often prepaid.
The U.S. government has preferred to bail out the agencies that are now effectively bankrupt. As borrowers default on these agency loans, the agencies continue to either pay on their behalf or buy out the defaulted loan from the owners. This prepayment buying of loans can have a volatile affect upon the agency REIT's quarterly income, yield and asset valuation.
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.
These REITs must give away so much income that they cannot easily grow through retaining and re-deploying earnings. As a result, these REITs often choose to place secondary offerings in order to raise capital and hopefully increase market valuation through further purchasing.
Below, listed in alphabetical order, are six such Agency Mortgage REITs: American Capital Agency Corp. (AGNC), Annaly Capital Management, Inc. , Anworth Mortgage Asset Corporation (ANH), Capstead Mortgage Corp (CMO), Cypress Sharpridge Investments (CYS), Hatteras Financial Corp (HTS). I have provided 2012-to-date, 3-month and 6-month equity performance statistics, as well as the current yield each REIT now offers.
Agency Paper Risks
Washington has not yet developed a reasonable substitute to the current agency system that, arguably, should have never existed. Still, government interaction within the mortgage world is unlikely to completely decouple in the coming years. Any future change to the industry could conceivably shut down this portion of the REIT industry, if the future supply of agency paper were eliminated, while prepayments continue.
Agency mortgage REITs must also react to changing interest rates. These REITs obtain their lofty yields through high leverage. These companies all have far more debt than their asset or market values, and make money off the spread between their borrowing costs and the MBS interest payment. Each company has a proprietary allocation of fixed and adjustable rate securities, and with differing call rules.
The current leverage rates are somewhat unclear, but these agency REITs will mostly file Q4 reports in the next 2-3 weeks. Prior leverage rates were between 5x-10x the equity of the REITs. If a highly levered mREIT does get caught on the wrong side of an interest rate spike, the effect to book value will be significant. Rising interest rates will also largely reduce spreads.
If rates do increase, many investors will likely flee the mREIT industry. Many current investors do anticipate selling when they see this future need on the horizon, but now feel confident that ratses should stay low diring 2012 due to expectations established by the U.S. Federal Reserve.
Several investors may likely be surprised by the leveraged moves that may hit this asset class, but in the interim the yield is now hard to beat or ignore. Provided interest rates and prepayments stay at or near their present levels, these agency REITs appear poised to continue churning out significant dividends in the coming quarters.
Additionally, because these REITs are taxed as ordinary income and do not qualify for the lower corporate dividend tax rate, many investors prefer holding them in tax-sheltered accounts, such as an IRA.
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. I am long NLY.