How Safe Are mREITs From The Perspective Of A Preferred Investor?

by: Norman Roberts


How safe are mREITs? Do they ever go bankrupt?

There are three main types of REITs: Mortgage, Equity, and a Hybrid.

I spotlight and propose that mREITs are a relatively safe vehicle for preferred investment.

The fact that mREITs utilize high leverage is concerning and in need of discussion.

Having presented my case, it's time for the SA members to offer comment and criticism.

I'm presenting this as a different type of SA article, one meant to stimulate thoughtful and intelligent conversation, with the end result that contributor and commenter alike equally share and benefit from the resultant forum. My function will be to provide the basis for this conversation, and then act as sort of a glorified moderator; adding information when I am confidently able to, and keeping silent when I can't.

Had you read my previous posts and articles, it's obvious I'm admittedly not the greatest trader, nor am I the most qualified to competently decipher complicated financial statements and other company reports that, more often than not, are spun to present the company in the most favorable light. My skill and expertise, what I pride myself on, and what allows me the confidence to function as a SA contributor is that I have extensively studied, learned, and utilized that knowledge to successfully and lucratively invest in a broad variety of preferred, fixed income, equities.

Before I continue, it's important you understand what my definition of safety actually means. As a long-term hold, cumulative, preferred investor I am not overly concerned about common stock price gyrations of companies whose preferreds Iintend to invest in. However, during times of extreme volatility, either of the individual company, its sector, or the general market, I make certain to monitor price movement and volume of the common shares (companies I am interested in making an investment) traded during each day. In fact on my trading platform, I have opened a page dedicated exclusively to the commons of the companies whose preferreds I am interested in investing in. I have set this up, primarily, because the normal volume of their common shares usually trades in million as opposed to mere thousands of a particular company's preferred counterparts. I believe that this better allows me to guage the sentiment of a significantly larger number of the particular company investors that interests me. Because single-handedly, on occasion, I have moved the pricing of a particular company's preferred position by the sale or purchase of just a few shares, I've determined this to be a terrible way to get a feel for the general sentiment of shareholders of any particular company.

I have chosen to open Part I of this forum with an in-depth study of the Mortgage REITs or mREITs, one of the three basic REIT sub-sectors. The other two are the Equity REIT and a combination of the two, a Hybrid REIT, which holds mortgages and actual hard Real Estate assets. I've chosen REIT's primarily because they offer a higher than average percent yield return, and rightly or wrongly, I have always considered them a relatively safe bet, as mentioned above.

According to Investopedia:

3 Main Kinds of REITs in the U.S.

1. Equity REITs invest in and own properties, that is, they are responsible for the equity or value of their real estate assets. Their revenues come principally from leasing space-such as in an office building-to tenants. They then distribute the rents they've received as dividends to shareholders. Equity REITs may sell property holdings, in which case this capital appreciation is reflected in dividends. Timber REITs will include capital appreciation from timber sales in their dividends. Equity REITs account for the vast majority of REITs.

2. Mortgage REITs invest in and own property mortgages. These REITs loan money for mortgages to real estate owners, or purchase existing mortgages or mortgage-backed securities. Their earnings are generated primarily by the net interest margin, the spread between the interest they earn on mortgage loans and the cost of funding these loans. This model makes them potentially sensitive to interest rate increases. In general, mortgage REITs are less highly leveraged than other commercial mortgage lenders, using a relatively higher ratio of equity to debt to fund themselves.

3. Hybrid REITs invest in both properties and mortgages.

Although there are a large number of mREITs, for obvious reasons I am only concerned with those that offer preferred equities. Those that don't, as listed here, are of no concern for this discussion. Two examples of these are: Chimera Investment Corp. (NYSE:CIM) and Ellington Residential Mortgage (NYSE:EARN).

For this forum, and to keep our focus narrow, of the many, I have chosen no more than five mREITs to review. They are: Armour Residential (NYSE:ARR), Apollo Residential Mortgage (NYSE:AMTG), AG Mortgage Investment Trust (NYSE:MITT), Invesco Mortgage Capital (NYSE:IVR), and CYS Investments (NYSE:CYS). Each are pure-play mortgage REIT's, and, as a class, they are less highly leveraged and, consequently, potentially less sensitive to interest rate hikes, which, I believe makes them less prone to the risk of bankruptcy, the bane of my investing existence.

Armour Residential is a large cap stock, which means it is valued over $1 billion, Usually, but not always, what I consider a safer selection with bankruptcy in mind. Although its common stock price has trended down for the past year, I am not overly concerned by this because of my low fear of bankruptcy, and during this time I was able to secure several thousand (ARR-A) preferreds, at, what I consider,, bargain-basement prices averaging $21.62/share. Furthermore, its yearly dividend is 2.0625, which means the effective yield for this investment is 2.0625/21.62 = 9.54%, a nice return for what I consider a safe, fixed income investment.

I invite you to examine an outline of its prospectus at Quantum Online cued for you reading pleasure. Notice, I try to be an opportunity investor, targeting my purchases during times of reletively high volatility when prices are relatively low and yields accordingly high.

For the overly cautious and savvy investor, I have provided a link to Armour's web page where, if you are inclined to, you are free to do additional due diligence. I am presenting it this way because I claim no particular expertise concerning this business model, which I don't entirely understand considering allof its moving parts: Interest variations, derivative trading, premium and discount buying, etc. Consequently, I have designed this article to serve as a basis for a forum, whereby, I hope to learn along with my audience, many of which, I'm certain, know a heck-of-a-lot more about this class of investments than I do. I simply want to know if I am correct in assuming that although these enterprises might lose value, and even cut their common and preferred dividends, that they rarely go bankrupt.

Apollo Residential Mortgage is a small cap stock valued at just under a half billion dollars, which along with most of its sector has faced a difficult year. Its common stock was at $15.80, March 2015, now at $13.14, although has moved higher since February 11, when it hit a low of $9.51.

Although this mildly concerns me, I feel my preferred investment at the average price of $21.45 is still relatively safe; simply because I do not envision enterprises such as these going bankrupt. However, this forum is designed for you, the reader, to disabuse me of this notion if you consider it incorrect. Recall, my investment parameters, if they don't go bankrupt, my investment is safe even if, for a time, the preferred price is below what I paid for it; which at present is not. To the math: Purchase price 21.45, yearly dividend $2.00 (today's price which really doesn't overly matter to me), hovering around $21.80. Consequently:

2.00/21.45 = 9.32% yield, which I have earned for 2 years and one month, which equals $4.50 in already collected dividends.

A link to Apollo's web site might be useful if you want to do further company research.

AG Mortgage Investment Trust a REIT that invests in, acquires, and manages a diversified portfolio of residential mortgages and other real estate related securities. It is a small cap stock with a market cap of $362 million. Small for a mREIT. As with its mREIT peers, it has not had a good year; although, its common share price jogged up recently in lockstep with many of its peers.

MITT Preferred Equities as of 3/15/16

Symbol Yearly Dividend Cost Dividend/Cost Effective Yield Best Choice
MITT-A $2.0625 22.60 2.0625/22.60 9.13%  
MITT-B $2.00 21.78 2.00/21.78 9.18% Best
Click to enlarge

Notice how the above effective yields mirrors the fact that these preferreds, in my opinion, are of low to moderate risk, which offer a nice, yet not overly excessive percent yield. Its risk/reward is certainly within reasonable balance. Another indication that my risk assessment of mREITs is one of comfortable safety. I feel the above table lends proof to this fact: that in spite of the negative trend experienced by this company individually, and this sector as a whole, its preferred prices have held up remarkably well, not terribly below its IPO $25.00 per share offering.

Additional information about its available preferreds can be found at Quantum Online. Simply click on the find related securities link, which will take you to both. And, if you want to further study this company, this link will take you to its web page.

Invesco Mortgage Capital is a large cap company with an over $2 billion market cap, which is primarily focused on financing and managing residential and commercial mortgage-backed securities and mortgage loans that are government backed. Another, what I consider, a risk-free preferred investment. IVR offers two preferreds as outlined below:

IVR Preferred Securities as of 3/15/16

Symbol Yearly Dividend Cost Dividend/Cost Effective Yield Best Option
IVR-A 1.9375 $21.30 1.9375/21.30 9.10%  
IVR-B 1.9375 $21.10 1.9375/21.10 9.18% Best
Click to enlarge

Of course, because both the above are virtually identical, the best buy option will changeon a regular with price gyrations. However, considering the size and relative safety, a preferred investment in this company, in my opinion, is a no-brainer, and coupled with a respectably high yield, a home run. As requested, I beg your comments in agreement or opposition to this claim.

As always, I invite you to do your own due diligence, first by visiting IVR's preferred page on Quantum Online, then click on finding related securities. Additionally, Invesco's web site might be helpful if you want to dig further into the numbers. Not my strong suit. I am a wildly successful investor because following Shakespearean advice, "To thine own self, I'm true," I determined, after grudgingly accepting the limitations of my market-knowledge, I decided either I would leave the market, bruised and battered by its catastrophic fall during 2008, or I could figure out how to play it on my terms, which meant that I would concentrate my efforts on becoming, not a jack of all trades, but an ace at one. Preferred investing became my ace.

CYS Investments Concentrates their investments in mortgage pass-through securities, which are federally guaranteed. Another large cap with over a $2 billion market value. As far as I'm concerned and safe vehicle for preferred investment.

CYS Preferred Equities as of 3/16/16

Symbol Yearly Dividend Cost Dividend/Cost Effective Yield Best Option
CYS-A 1.9375 $22.97 1.9375/22.97 8.44%  
CYS-B 1.875 $22.00 1.875/22.00 8.52% Best
Click to enlarge

Best yield and best upside potential. If called, the B Series will earn you .97 more per share and a .08% ongoing yield upside. Of course, I like higher yields because I tend to be greedy, and given my circumstance, I can afford to take greater risk. For the risk adverse, this is a nice investment, one you can safely leverage. I suggest you read my article concerning leverage and margin.

Finally, and this might be a fly in the ointment, one in which I don't feel competent to competently evaluate, although, I know it's important I add it to the discussion. Hopefully, it will be thoroughly discussed and determined whether or not we need be concerned at all. The problem concerns the leverage I just wrote about, which is apparently a normal practice for mREITs, who leverage on the average of 8:1; something I find a bit frightening. I am listing the reported leverage D/E (Debt/Equity) of each of the five companies discussed below:

  • ARR - 9.44%
  • AMTG - 4.2%
  • MITT - 4.08%
  • IVR - 7.25%
  • CYS - 7.76%

Obviously, ARR utilizes the highest leverage and might be the most at risk should the market turn against it. And to muddy up the waters further, I am quoting a relevant article, in its entirety, submitted in 2012 by a fellow SA contributor, Jack Rice:

"Leverage has a mixed history. On one hand, leverage -- the use of borrowed capital to magnify returns -- has helped enrich individuals and companies. On the other hand, one need only recall the 1929 Wall Street crash to see how leverage, in the form of margin, can lead to ruin.

A company that needs to raise capital can take the leverage or equity path. If inflation is high or money is cheap, then leverage may be the solution, since high inflation favors the borrower, and cheap money put to work can earn more than it costs. On the other hand, if times are uncertain and money is expensive, then the sale of equity may be preferable, since it adds nothing to debt. The downside of selling equity is that it can dilute assets, which has the effect of lowering share price.

Mortgage REITs use both leverage and equity to augment earnings and to replenish and grow assets. The difference, or spread, between the interest an mREIT pays to borrow funds (usually as repurchase agreements or "repos") and the interest it earns on the mortgage-backed securities (MBS) it buys with those borrowed funds is around 2%. This in itself is not a big yield. So mREITs leverage, or borrow in multiples of stockholder equity, in order to multiply the spread by the leverage factor. Thus, if the leverage factor is 8 on a 2% net spread, then the effective spread is 16%. 90% of the resulting earnings (plus base asset yield less expenses like management fees and hedging costs) are distributed to shareholders.

Unlike other entities, mREITs can only retain 10% of earnings, so the mREIT uses equity, in the form of secondary share issues, to fund its asset replenishment and growth.

investors considering mREITs are often put off by what they consider the high leverage mREITs use to generate their double-digit yields, which are far superior to the payouts of other investment sectors. Because of the history of catastrophes brought on by leveraging, it's a well-founded fear, and certainly "this time it's different" is a familiar refrain to the jaded ear of the experienced investor. So I leave it to an mREIT, American Capital Agency Corp. (NASDAQ:AGNC), addressing the Securities and Exchange Commission, to speak to the issue of leverage:

As of June 30, 2011, the Company's debt ratio was 88.23 -- just under an 8-to-1 debt-to-equity ratio. By contrast, as of June 30, 2011, the average debt ratio for all institutions insured by the Federal Deposit Insurance Corporation (the "FDIC") was 88.70 - just under a 10-to-1 debt-to-equity ratio. Moreover, as of June 30, 2011, some of the largest insured deposit institutions had higher debt ratios than the Company, including Wells Fargo Bank, N.A., with a debt ratio of 88.79; Citibank, N.A., with a debt ratio of 89.49; U.S. Bank, N.A., with a debt ratio of 89.77; and J.P. Morgan Chase Bank, N.A., with a debt ratio of 93.00. Even in interest rate environments where there was considerably less interest rate risk than in the current environment, our leverage was slightly below the average leverage levels employed by banks and other financial companies, which we believe have riskier businesses than ours. In addition, our leverage is also limited by the fact that our lenders are subject to governmental restrictions on the amount they can lend to individual borrowers.1

Annaly Capital Management (NYSE:NLY) is more succinct:

The majority of Agency MBS investors are leveraged. Banks, insurance companies, foreign financial institutions and many private investors use varying degrees of leverage, while the GSEs themselves and the Federal Reserve are infinitely levered.2

As the recent JP Morgan trading fiasco attests, today's banks indeed have "riskier businesses" than mREITs. Just one aspect illustrates: hedging. Because of the repeal of the Glass-Steagall Act, banks have been free to "play the market." Hedges, such as options and swaps, which traditionally were used to reduce risks, have become speculative instruments in themselves, with the result that they become a larger share of risk than the assets they would otherwise cover. Mortgage REITs use hedges for their intended purposes only, to reduce risk rather than add to it. mREITs can thus be seen as closer to traditional Glass-Steagall era banks than today's banks, thus bolstering AGNC's assertion that mREITs' mortgage investments are less risky than banks' and warrant the use of leverage integral to the mREIT business model.

Generally speaking, mREITs will adjust leverage, as they adjust their portfolios, to meet changing environments. AGNC gives one example of how an mREIT adjusts its leverage:

[W]hile we closed the quarter at 8.4 times leverage, which was on the higher end of where we've operated over the last two or three years, we said we have brought that down, because valuations and April had been very strong, and we felt that the risk return was much more two-sided. So we've brought that down some.

But one thing that we stressed was...we were very reluctant to be at low leverage, going into...a scenario where there was a reasonable probability of a QE3. Why? Because when you're underweight or when you have low leverage, that means that you're kind of saying, I'm going to buy later.

Yes, you could potentially maintain that for a long period of time, but you're still -- especially if you have faster securities -- going to be doing a lot of reinvesting. And you're going to be competing with a multiple hundred-billion dollar program from the Fed. The...last thing we want to do is wait till the Fed starts buying, to then...increase our purchases of mortgages.

We'd rather, if anything, reduce our purchases going forward if the Fed drives mortgage prices to...extreme levels. So for that reason, we weren't comfortable in running with...low leverage in that kind of environment.3

If the increasing popularity of mREITs is an indicator, then one might say, about the two forces that govern the market, that greed has overcome fear. But even within the mREIT space, one can accommodate his personal greed/fear ratio. Different mREITs employ different levels of leverage. For example, AGNC employs a leverage factor of 8.4 at last report. On the other hand, NLY employs a leverage factor of 5.8 at last report. Normally, leverage is reflected in mREIT yields, thus, all other factors being equal, the lower the mREIT yield, the lower the leverage, by which one might infer a more conservative leverage strategy. Nevertheless, higher leverage not only increases yield, but can also be, as AGNC maintains above, a prudent strategy.

That said, it must be acknowledged that mREITs addressing themselves to regulators suggests the risk of regulatory intervention on how much leverage mREITs are allowed. In fact, regulatory intervention may be the single biggest risk in the mREIT space. On the other hand, it should be comforting that with regulators looking over their shoulders, the mREITs will be on a mission to prove that their leveraged business is legitimate and sound.

Summary: Leverage is integral to today's mREIT business model and is not applied at higher levels in the mREIT sector than in other financial sectors."

Now it's time for audience participation. I invite your comments and any useful information you care to add to this discussion. In this way we will all profit from the experience. Remember, I am almost exclusively a preferred fixed income, long-term-hold investor.

Disclosure: I am/we are long ARR-A, ARR-B, MITT-B, CYS-B, IVR-A.

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.