it's been more than three years since we first wrote on Seeking Alpha about mortgage REITS ("American Capital Agency: Making Money the Old-Fashioned Way"). In the wake of American Capital Agency Corp.'s (NASDAQ:AGNC) 2011 annual result, it's worth looking at how the company has done and what its prospects appear to be for the future.
In early September of 2008, American Capital's first full quarter's results hadn't yet been reported. On the date of the earlier article's publication, shares traded south of $20 and shares were elsewhere described as paying a 31¢ dividend (based on the stub-quarter dividend paid for the first fractional quarter of operations ended in June). The fact that American Capital had produced 37¢ of income in 27 days suggested that (a) annual profit appeared in the range of $5, and (b) undistributed (that is, reinvested) profit was being made at the rate of 81¢ oer year, while (c) the company was on track to pay a dividend in the range of $4.19 per share (while building book value).
Although article coments recognized American Capital's 8x leverage as "better than most banks", its performance was nevertheless criticized as the product of "the best of all possible worlds to start in" and sustainable only "as long as the yield curve is steep." Management has weathered some chaotic financial environments since then: The financial meltdown, the lowest mortgage rates in recent history, and threats to the credit rating of the United States (a critical guarantor of agency-backed mortgages). Over this time, American Capital's management (supplied by asset manager and private equity firm American Capital Ltd. (NASDAQ:ACAS)) has maintained a double-digit dividend rate while methodically raising net asset value per share from just below $20 (the post-fees IPO proceeds) to $27.71 at the close of 2011. The dividend - currently set at $1.25 per share per quarter - is about 16.6% of American Capital's current trading price of $30.17.
REIT dividends are based on their taxable income, which can vary materially from SEC-reportable "income", which includes unrealized gains that do not constitute taxable income. In the case of American Capital, Q42011 earnings were $2.27 per share, which included $1.28 in "other comprehensive income" (a category that embraces gains in value in interest-rate swaps, used to hedge interest rate risk). Net spread income for the quarter was 98¢ per share, and taxable income was $1.61 per share.
The recently-announced 1Q2012 dividend of $1.25 per share (a rate of $5 per year) appears well within American Capital's taxable income, and in combination with unrealized gains, is set to leave significant room for NAV growth.
Is this sustainable with today's low home mortgage rates?
As described in the prior article, American Capital's business plan depends on being able to buy mortgage investments that pay a higher rate than American Capital must pay for invested funds. This underlying yield spread is then multiplied by American Capital's total invested funds (including both borrowed money and American Capital's permanent equity). With rates this low- and promises they may go lower- one must legitimately ask about the future of the model. As reflected by management's optimism in the last earnings announcement, that news is pretty good.
American Capital's yield spread is not based on the difference between the rate at which homeowners might borrow short-term and the rate at which they actually finance their homes (often for terms as long as 30 years). Rather, American Capital's net interest spread is the difference between the rate at which American Capital can borrow against mortgages whose principal and interest are backed by Congress (that is, a United States agency guaranty backed by Congress' power to spend) and the rate at which retail borrowers in fact finance their homes. When it borrows against government-backed obligations, the credit of American Capital is rather different than the credit of individual home buyers in a market that understands the potential volatility of home values. As such, there is rather a substantial basis for yield spread that does not depend entirely on yield curves.
Unless Congress publicly abandons its commitment to home ownership by ceasing home loan guaranty programs - and becomes willing to risk the liquidity of home loans that increases their value to U.S. lenders - the mortages American Capital is able to buy will continue to remain good collateral for those it relies on to provide its leverage. The federally-backed entities providing the loan guarantees behind American Capital's portfolio (described as "crucial cogs" in the market) cannot be easily eliminated. They play an essential role in making mortgages sufficiently liquid to enable the thriving secondary market that makes mortgages attractive to the originating lenders. This, in turn, makes middle class home purchasing possible. Without the guaranty, credit availability would plummet. Backed by both the federal guaranty and the lien each mortgage enjoys on the real property purchased with the mortgage proceeds, American Capital's collateral is tough to beat for solidity. (The liens are security interests in real estate, which allows American Capital to qualify as a REIT.) And so is the rate American Capital can get when borrowing against its holdings; the rate spread is more solid than some detractors seem to suggest.
How Did American Capital Perform In 2011?
At the dawn of 2011, American Capital had a NAV of $24.24 per share and paid a quarterly dividend of $1.40. Over the 2011 calendar year American Capital earned $7.50/sh, including $4.66/sh in net spread income. Taxable income (on which a REIT's mandatory minimum dividend is calculated) was $6.70/sh. The company paid $5.60/sh in dividends while growing NAV $3.47 per share to $27.71. Part of that NAV growth came from above-NAV share issuance, which is possible so long as ACAS trades at a NAV premium as it does at the time of this writing: at $30.19, American Capital trades 8.95% above its last-published NAV. When American Capital issues shares above NAV, it does not "dilute" shareholders' investment, but increases their post-transaction NAV per share.
American Capital's repeated share issuance has helped it grow its portfolio to $55 billion at the close of 2011. Although American Capital had an average leverage of 7.6x over the last quarter of 2011, this average leverage was likely impacted on a transient basis by a $1.1 billion follow-on offering that doubtless took a certain amount of time to fully invest. At the close of 2011, American Capital had returned to 7.9x leverage. Net interest rate spread at the close of 2011 was 1.90%, which based on its year-end leverage suggests a going-forward income approaching 17% on its net spread.
What's the Future Hold?
American Capital must set its dividend within its means, and reducing it 15¢ per quarter to $1.25 ensures that remains the case. At $5 per year, the announced dividend suggests a return exceeding 16% (at current market prices, which are nearly 8.9% higher than American Capital's NAV). This also enables American Capital to continue raising its NAV by reinvesting undistributed income. And as goes NAV, so goes share price. American Capital's return since the publication of the 2008 article has included not only over 50% in share price appreciation (from the $18.62 close the last trading day before publication to the current price of $30.17 is a gain of $11.55, or 62%), but also $17.05 in dividends. Without reinvestment (and ignoring proceeds earned following payment of dividends), this amounts to a gain exceeding $28 for a total return over 250% (i.e., a gain over 150%) since early September of 2008. Reinvestment in a tax-deferred account would magnify that somewhat for those in a position to have enjoyed it. With double-digit dividends going forward and apparently ongoing NAV gains, the future looks attractive.
It's not an exciting business, and might not be in the news much, but it's been a reliable business and more of the same is more than welcome.