Thoughts On A Handful Of mREITs And The State Of The Industry (Week 23)

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Includes: AGNC, AI, AMTG, ANH, ARR, BXMT, CHMI, CIM, CMO, CYS, DX, EARN, JMI, MFA, MORT, MTGE, NLY, NRZ, NYMT, ORC, REM, STWD, TWO, WMC, ZFC
by: ColoradoWealthManagementFund

Summary

The focus this week is on the rise seen in agency mREITs.

There are a few theories I can come up with, but none of them justify these higher prices.

I'm struggling to find investments where I'm confident with a buy rating. Finding "short" candidates may be easier.

Welcome to week 23 of my thoughts on a handful of mREITs and the state of the industry. I spent quite a while this week working on some of my most challenging tools used for predicting book value for individual mREITs within the quarter. There is still quite a bit of work to be done, but some great progress has been made. While I'm working on the models, I've also been thinking about the industry and the incredibly strong pricing we are currently seeing across some of the agency mREITs.

The mREITs (and two ETFs)

The table is demonstrated below:

(NYSE:NLY)

Annaly Capital Management

(NASDAQ:AGNC)

American Capital Agency Corp.

(NYSE:ARR)

ARMOUR Residential REIT

(NYSE:CMO)

Capstead Mortgage Corporation

(NYSE:CYS)

CYS Investments

(NYSE:DX)

Dynex Capital

(NYSE:JMI)

Javelin Mortgage Investment

(NASDAQ:NYMT)

New York Mortgage Trust

(NYSE:ORC)

Orchid Island Capital

(NYSE:TWO)

Two Harbors Investment Corp.

(NYSE:WMC)

Western Asset Mortgage Capital Corp.

(NYSE:MFA)

MFA Financial

(NYSE:EARN)

Ellington Residential Mortgage REIT

(NYSE:AI)

Arlington Asset Investment Corporation

(NYSE:ZFC)

ZAIS Financial

(NYSE:AMTG)

Apollo Residential Mortgage

(NYSE:ANH)

Anworth Mortgage Asset Corporation

(NASDAQ:MTGE)

American Capital Mortgage Investment

(NYSE:CHMI)

Cherry Hill Mortgage Investment

(NYSE:STWD)

Starwood Property Trust

(NYSE:BXMT)

Blackstone Mortgage Trust

(NYSE:CIM)

Chimera Investment Corporation

(NYSE:NRZ)

New Residential Investment Corp.

(NYSEARCA:REM)

iShares Mortgage Real Estate Capped ETF

(NYSEARCA:MORT)

Market Vectors Mortgage REIT Income ETF

Click to enlarge

Strength

The rapid rise among the agency mREITs can be demonstrated effectively by Orchid Island Capital. On January 25th, the REIT closed trading at only $8.23 per share. It was exceptionally undervalued at the time, and it was about that time that I had to call off my short rating. Since then, the shares have rallied dramatically, and they closed Friday at $10.43. During that time, the REIT also paid a dividend of $.14. Not too bad, but this rally has gotten out of hand.

For clarity's sake, I think $8.23 is certainly too low and $10.43 is certainly too high. Some arguments can be made about reasonable trading ranges for ORC, but I don't see any that would favor these prices.

While some of the mREITs have done poorly, especially those tied to higher-risk assets that were trading at substantially smaller discounts to book value, the ones I'm focused on are the names I cover frequently. These mREITs like NLY, AGNC, CYS, ORC, and ARR have seen their discounts to book value shrinking. In most cases, it has been a function of declining book values and rising share prices.

ARR hasn't seen much of a rally in relative terms, but I believe its hedge book got hammered so far this quarter. I'll try to have more research out on that within the next few days.

Arguments

I can come up with a few arguments for why share prices are rising, but none of them are built around the fundamentals of the mREIT themselves. Those fundamentals have been deteriorating as the yield curve flattens.

Here are the arguments I've been able to come up with:

  • REITs will get their own sector in the S&P 500.
  • The market is assessing and believing a higher probability of "lower for longer" on interest rates.
  • Very low LIBOR levels indicate the ability to enter cheaper hedges.
  • Investors are betting MBS yields will be higher than the direct buyers for MBS believe.
  • The U.S. could be heading into a recession, and the agency mREITs are expected to outperform.
  • Investors are simply feeling dramatically less risk-averse.

Assessments

I find each of those arguments to be terrible, though I think they could influence perception, and in the short term, it is perception rather than fundamentals that will drive pricing. In the long term, fundamentals should be the controlling factor.

REITs getting their own sector in the S&P 500 could offer some help to equity REITs as more demand for equity drives down the WACC (weighted average cost of capital), which makes it easier for them to make accretive acquisitions. The only way higher prices can improve fundamentals for mREITs is if they allow them to trade over book value and issue new shares at accretive prices to create immediate gains to book value. That is very useful, but I wouldn't want to bet on it.

Lower for longer on interest rates seems great, but most of these agency mREITs were already hedging the substantial majority of their cost of funds. So long as the variable rate on a LIBOR swap moves with the repo cost, the direct impact of a change in repo costs is significantly limited.

The very low rates on LIBOR swaps make hedging cheaper. That is true, but an mREIT hedging out most of its interest rate risk and reporting the yields currently available on MBS would need a weaker dividend yield as a percentage of book value than most of the mREITs are currently paying. If the hedges are cheaper than they used to be, but still too expensive to use without cutting dividends, is that really an argument for huge price increases?

If investors in mREITs believe MBS yields will significantly outpace the level that is projected by the buyers of MBS (such as the managers of mREITs), then I must sincerely doubt their conclusion.

If the expectation is that mREITs outperform in a recession and we are headed for one, investors should try to explain why the S&P 500 is on such a dramatic climb. I'm concerned about the potential for a recession, and I recently decreased my stake in the major indexes, but I'm not convinced the recession will actually occur. I simply see too much risk in the long positions relative to holding cash. Keep in mind that the rise in these mREITs goes along with a rise in the S&P 500, which makes this argument less compelling.

The final argument is that investors are simply feeling less risk-averse. I think there is a fairly solid possibility this is happening, but I don't see it as a reason to buy into the hype. I would like to buy when there is blood in the streets, and that seems to be in short supply.

Conclusion

The share prices for mREITs are rising, but the fundamentals don't justify it. Every solid argument for why the mREITs are rising relies on market perception rather than the fundamentals. The fundamentals can be boiled down to the net interest spread. If a large net interest spread can be generated while accounting for a reasonable level of hedging, the sector is fairly attractive. When the yield curve flattens, it results in weaker net interest spreads. If the yield curve were to become materially steeper, it would indicate mREITs suffering substantial losses on either their MBS or their hedges. Note that for the short end to move materially lower, it would require negative rates. While negative rates are possible, I do not expect it to happen in the United States.

Instead, I see prices climbing to new highs each day while the net interest margin erodes. I see dividends that will need to be cut due to the weaker net interest margin. I'm still looking for opportunities and hoping to find something, but I don't see an abundance of attractive options. To keep my options open, I'm still marking this article that I may buy anything, but my overall view is that there is more risk than potential return.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ANY OF THEM OR THEIR PREFERRED SHARES over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.