Understanding 15% mREIT Yields For Retail Investors

by: Todd Johnson

Mortgage real estate investment trusts (mREITs) offer enticing 15% - 18% dividend yields. Investors seek high yields, but common sense says "there must be a catch". In this article I would like to explain why the retail investor can obtain a 15% dividend yield. The focus will be on how these yields are achieved and what you are truly investing in.

mREITs versus Seadrill (NYSE:SDRL):

Seadrill is the "Typical" Stock
Seadrill Limited is an offshore drilling company that plans ahead via contracts with energy producers . The company has arguably the most modern fleet of ultra deep water contracts. The fleet allows oil companies to extract oil in deep water locations.

I use Seadrill as a typical stock. If the earnings are not positive, or if they post a loss, then it is quite possible the dividend will be reduced or eliminated. Their business model is established and their revenues are from 3rd parties hiring Seadrill's fleet for oil projects.

As investors, we recognize Seadrill as a typical common stock. The company will thrive or fail if earnings do not increase and if dividends are not paid. Revenues are established from services and products. This is not how an agency mortgage real estate investment trust operates. Here is the twist you much understand.

Agency mREIT Business Model
Agency mREITs, such as Hatteras Financial (NYSE:HTS), own only Government Sponsored Entity (GSE) securities. They are 100% backed Federal Government mortgage backed securities. .

Hatteras invests in residential mortgage backed securities (RMBS). These securities are issued or guaranteed by the U.S. Federal Government or U.S. Government. Agencies include Ginnie Mae, Fannie Mae, Freddie Mac. The external advisor of the agency mortgage backed securities is Atlantic Capital Advisors LLC.

Agency mREITs Risks
Agency mREIT risks were addressed in my prior article, "The mREIT Playbook: Lots of Rewards, But Lots of Potential Risks As Well". The key business risks are Prepayment Risk, Spread Risk, Interest Rate Risk, Liquidity Risk, and Extension Risk. Agency mREITs do not possess credit risk because agency mortgage backed securities are 100% backed by the Federal Government.

As an investor I have found Gary Kain, Chief Executive Officer, to be a wealth of information. American Capital Agency (NASDAQ:AGNC) has provided investors a 28.0% total annualized rate of return over the past 5 years.

Hatteras management has been more than helpful with understanding their business model. They have explained, via interviews, their business model which is slightly different than other agency mREITs. They focus on securities which have a slightly shorter maturity time frame.

American Capital Mortgage (NASDAQ:MTGE) is a hybrid mortgage. This means the mREIT can invest in mortgage backed securities backed by the U.S. Federal Government and non guaranteed securities. Fortunately, Gary Kain manages the agency mortgage backed securities for American Capital Mortgage. The mREIT is 100% intentionally planned, at the present time, to be invested in primarily U.S. Federal Government agency backed securities. Please follow American Capital Mortgage closely to notice any differences.

Please understand what a mortgage real estate investment trust is. It is not a stock. It is a levered bond fund. mREITs do not sell products or services like Seadrill. They borrow funds via short term repurchase (repo) agreements and buy longer duration agency (Fannie Mae, Freddie Mac, and Ginnie Mae pass through securities) instruments. Agency mREITs then lever the position to about a 7x - 8x position. This leverage ration used to be higher in prior years.

Important Note: Please Remember
The investor has to filter out the noise, filter out inaccurate information, and come to the one correct conclusion. Agency mREITs are simply levered bond funds. A dividend cut simply means that the net yield margin has compressed or the markets are not moving in the positive direction for mREIT benefits. These positions are not regular stocks. They are financial companies that hedge their interest rate positions via derivatives.

I have tried to focus on quality agency mREIT management teams. If the investor wants to enter the non agency mREIT sector, recognize you are dealing with assets not backed by the U.S. Federal Government.

Seadrill is in a different asset class as an agency mREIT. Nobody will spell this out for you. You have to understand the agency mREIT business model and why the difference is material. If you do not understand this concept, then a "dividend cut" or "negative news" press release could be misconstrued by you. Now if the investor wants 15% yields, then simply understand the basics, stick with the winners, and you will send a "thank you" card to the mREIT management team one year from now. Focus on the facts, and ignore the misinformation.

I send my "thank you" email on a semi annual basis.

Disclosure: I am long NLY, HTS, AGNC, MTGE, SDRL.