Master limited partnerships (MLPs) and mortgage-backed real estate investment trusts (mREITs) are among the top choices of income-oriented investors. These investment vehicles offer yields that are much higher than the average yield in the equity markets. Thanks to their nifty yields, both investment vehicles are preferred by income-oriented investors.
The distributions provided by these companies are subject to favorable tax rules. mREITs are exempt from corporate taxes as long as they distribute at least 90% of their income in the form of dividend payouts. MLPs are not tax exempt, but their distributions can be registered as capital depreciation, effectively reducing their tax base. MLPs and mREITs could be good substitutes for each other in a yield-oriented portfolio. However, their business models are completely different.
Master Limited Partnerships - Business Model
While there are several ways to define MLPs, The National Association of Publicly Traded Companies offers the best description:
MLPs, like all publicly traded partnerships, are limited partnerships or limited liability companies choosing partnership taxation which are traded on public exchanges. A share in an MLP is called a "unit," and MLP shareholders are known as "unit holders." MLPs can be found on the New York, American, and NASDAQ exchanges, as well as many regional exchanges.
Most MLPs operate as pipeline operators, which transport natural gas, oil, and similar liquids to terminals located near residential, industrial or commercial customers. Since they primarily act as transport agencies, they are less likely to be affected from the volatility in commodity prices.
Master Limited Partnerships - Valuation
Suggesting a fair value for a master limited partnership is a great challenge. It is not easy to evaluate MLPs since they have a lot of assets that are subject to significant depreciation charges. The depreciation expenses reduce their earnings on the balance sheet, with no real effect on the cash flow generated by the company. In the world of MLPs, cash flow is the best valuation criteria for the distribution safety. However, one needs to pay extra attention to the source of the cash flow. Most MLPs are heavily indebted, and they keep on borrowing and share dilution to support their cash flow. The generous yield, supported by a deceitful cash flow statement, creates an illusion of an undervalued company.
Overvaluation is a significant issue for the MLPs. The low-yield environment, created by quantitative easing program, has pushed several high-yield stocks to over-bought levels. Investors, hungry for stable income flows, have switched to bond alternatives such as MLPs, driving their unit prices above their fair valuations.
The Alerian MLP index (AMLP) which closely tracks the price and yield performance of the Alerian MLP Infrae structure index, currently offers a yield of 6.04%. The fund's top holdings are Enterprise Products Partners (EPD) and Kinder Morgan Energy Partners (KMP). Both KMP and EPD are pipeline operators. They offer substantial yields of 5%, and 5.64%, respectively. However, the free cash flow does not support the yield.
Sells: Kinder Morgan and Enterprise Products
In the last year, Kinder Morgan generated an operating cash flow of $2.87 billion. However, about $1.2 billion is spent for capital expenditures. After accounting for these expenses, the company is left with a free cash flow of $1.67 billion.
In order to support its yield, KMP issued a net debt of $1.1 billion and common units worth $955 million. Thus, it is leveraging its debt, while allowing for significant share dilution to support its yield. KMP's balance sheet shows a total liability of $16.595 billion, $3.1 billion of which is short term. The current assets are enough to cover only half of the current liabilities. To support its current distribution rates, KMP will either be forced to increase its debt load, or offer more units to raise capital, or both. The company is also trading at a significant premium to its book value. Therefore, I rate it as a sell.
In the last trailing twelve months, Enterprise Products Partners generated a cash flow of $3.084 billion from its operations. However, it spent almost $3.5 billion in property investments, which left the company with negative cash. Therefore, in order to keep up with the distributions, the company borrowed a net amount of $1.36 billion, and issued new units worth $596 million. As Emerging Money suggests, EPD has relatively thin profit margins compared to its peers. Its gross margin of 6.76% and net profit margin of 4.71% are below the industry standards. The debt to equity ratio is better than KMP, but this ratio is moving in an upward trend. After providing an annualized return of 37% in the last three years, EPD does not look as attractive as it was. Therefore, I also rate it as a sell due to over-valuation.
Mortgage-Backed Real Estate Investment Trusts - Business Model
The business model of an mREITs is totally different than that of MLPs. These companies are usually managed by external management teams. The management invests in securitized long-term loans, which are originally borrowed by the property owners. The financing comes from low-interest borrowing. Thus, these companies finance their long-term investments by short-term borrowing.
One can think of mREITs as giant investment funds, which invest in mortgage-backed securities. Note that in most cases, the original loan has been securitized through intermediate agents. Thus, property owners do not borrow from the mREITs. While mREITs are the ultimate financers of real estate properties, these parties actually have no direct connection with each other.
Due to their unique structure, mREITs are subject to several risks. Mortgage-default risk and yield-spread contraction risk are unique to mREITs' business area. Mortgage-default risk is specific to hybrid mREITs, which also invest in non-agency backed mortgage instruments. Yield-spread contraction risk is closely related to FED's monetary policy. Most mREITs use some sort of leverage to exploit the difference between short-term and long-term interest rates. Therefore, a reduction in the yield-spread can have a multiplicative effect on their future profits.
Mortgage-Backed Real Estate Investment Trusts - Valuation
Similar to MLPs, valuation of mREITs is a big challenge. Traditional equity valuation models might suggest deceptive valuations for these companies. Since most mREITs are highly leveraged, their debt/equity ratios are well-above market average. Another similarity between mREITs and MLPs is unit dilution. In order to keep their yields at the current levels, mREITs also issue additional units from time to time. The unit dilution does not have a direct effect on the company's market cap, but it reduces the distributions per each unit.
My safety criterion for mREIT valuation is a double-digit yield which is fully-supported by a single digit trailing P/E ratio. The stock should also be trading close to its book value. In fact a discount to book value is preferred, as mREITs rarely trade above their book value. Based on my safety criterion, Chimera Investment (CIM) and American Capital Agency (AGNC) look like good plays in this field.
Buys: Chimera Investment and American Capital Agency
Chimera operates as an investment fund that invests in both agency and non-agency issued mortgage-backed securities. As a hybrid mREIT, Chimera might sound like a risky investment; 74.5% of Chimera's portfolio consists of non-agency residential mortgage-backed loans. However, since these loans offer relatively higher interests, the company does not need a high leverage. Its leverage ratio currently stands around 1.85. The company offers a yield of 15.5%. Assuming a payout rate of 100%, its forward ratio of 6.31 suggests 15.8%. Insiders are also bullish about their stock, initiating several purchases over the last year. The company is also externally managed by the same management team of Annaly Capital (NLY). Therefore, I rate Chimera as a buy.
Another stock that fits into my safety criteria is American Capital Agency (AGNC). Unlike Chimera, AGNC is an agency-only mREIT, which invests only in agency-backed mortgage securities. It offers a yield of 17%. Assuming a full payout, the forward P/E ratio of 6.08 suggests a future yield of 14.7%. Therefore, a minor distribution cut might be on the horizon. However, the stock still fits well into my double-digit yield, single-digit P/E ratio criteria. Therefore, I also rate AGNC as a buy.