Thoughts On A Handful Of mREITs And The State Of The Industry (Week 27)

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

Summary

Mortgage REITs remain at a fairly high price level and I see the most appealing area as searching for buyout candidates.

The yield curve remains fairly flat which creates a problem for mREITs.

Dividend yields over 15% should be treated skeptically.

Based on new agency MBS with heavy hedging through LIBOR swaps, it would be difficult for an agency mREIT to earn more than around 10% from net spreads.

I’ll present a quick list of some potential candidates for mREITs that may announce dividend cuts later this year.

Welcome to week 27. Without much ado, I'd like to jump into the analysis for major factors influencing 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

What I'm Working On

I often work every day of the week and it doesn't bother me much. Having more time to do research is a competitive advantage. I've been pouring time into researching smaller mREITs and examining larger discounts to book value. I'm hoping to find compelling buy out situations because I believe discovering those buyouts before they are announced is one of the best areas to look for risk adjusted returns in this market.

In early March I put together a piece on MTGE. Based on the buyouts that had been seen recently and share prices across several mREITs I felt a buyout was improbable. Since then there was an acquisition of Hatteras Financial Corp. (NYSE:HTS) by Annaly Capital Management. I think that acquisition changes the playing field and the ideas about which mREITs are in play should be updated. I'm not moving so far as to say that a buyout is probable, but I am ending my previous outlook. I intend to do further research to assess the probabilities given the latest information.

Interest Rates and Price to Book Ratios

I put the following chart together last week to demonstrate the spreads on the treasury yield curve and the price to book ratio for Annaly Capital Management. Note that measurements prior to 2016 are only taken once per quarter for book value, price, and interest rates.

Click to enlarge

I want to add to it by including a table of the relevant spreads lately:

Click to enlarge

The most recent values are better than the other measurements I used so far in April, but they aren't enough to give investors reason to believe that the mREIT industry is in a great position for strong performance going forward. Spreads about 1% represent a fairly weak yield curve. It hasn't inverted, but inversion would be a very negative sign because it would encourage investors to believe a recession was coming. If it was near inversion, I think the Federal Reserve would work their jaw muscles hard to force long rates up. If we see that kind of event, there could be some sudden pressure on mREITs but it would be excellent for dividend sustainability.

Dividend Outlooks for the Sector

Several mREITs announced dividend cuts between late 2015 and the end of the first quarter. I believe there are several more cuts to come. For those cuts not to happen, I think there are a few possible scenarios. Acquisitions could occur that would prevent the need for cutting dividends. Management could decide to pay out book value to sustain the dividend. Creative hedging techniques could make it appear that book value was not being paid out, even if it was. A steeper yield curve would also be highly favorable. A further disconnection between LIBOR rates and treasury rates could allow mREITs to lock in lower rates. Specifically, I'm talking about the potential for LIBOR rates to move even further below treasury rates for identical maturities. This movement would damage book value but it would be favorable for allowing an mREIT to leverage up and lock in funding costs.

On the other hand, weakness in MBS coupon rates would produce a material challenge to agency mREITs. If the coupon rate on the MBS is low it will encourage high levels of refinancing which drags down the yield on existing assets and forces mREITs to reinvest at weak yields. This is a risk that is getting vastly less coverage than it deserves.

A Very Quick Rule of Thumb for Dividends

If you see a dividend yield over 15%, be very skeptical. I've run the math on new MBS, repo costs, and swap costs. I don't believe an mREIT can be heavily hedged through LIBOR swaps while investing in agency MBS and still produce a net yield on book value in excess of about 10% in this environment. Dividends exceeding about 10% of book value should be scrutinized carefully. Those exceeding 15% on share price or about 12% on book value are less likely to be sustained in full over the next couple of years. I would expect many to be cut within 2016.

Some Quick Candidates

I'm seeing several cases where dividends face a high probability for cuts but the share prices across the sector don't reflect my level of risk aversion. For this to be actionable, I'm fairly sure investors are going to want me to highlight several dividends that are at risk.

Arlington Asset Investment Corporation has a yield of 22%. I doubt their dividend sustainability. Orchid Island Capital is at 15.77% by my calculations though screeners are showing numbers over 19%. This one is questionable. If long rates on MBS move higher in the near future then I think they may be able to do it. If long rates remain depressed than I think elevated prepayments will hurt the interest income. ARMOUR Residential REIT recently cut from $.33 to $.27. I'm not sure about the new dividend; it'll take some further research.

New York Mortgage Trust is at a 19.3% yield. I expect a cut to be announced this year. I don't expect it to be a moderate trim. Dividend is currently $.24. I expect it to fall to $.21 or lower.

This list is not exhaustive. These are just the first ones that stuck out to me as warranting discussion.

Conclusion

The yield curve is slightly steeper but still remains fairly flat. There are a few potential developments that could occur that would be very positive for the sector, but I'm not interested in betting on them occurring. I think searching for buyouts is ideal, but it can require extremely intense due diligence in some cases. Predicting a buyout and betting on it is a tricky game and can carry some material risks.

I currently have active limit orders on two series of preferred shares and I plan to add more.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ANYTHING IN THIS ARTICLE, INCLUDING THE 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. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. 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.

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