Now that the market is questioning the Federal Reserve's monetary policy, investors who have flocked to mortgage REITs need to reassess their positions. Over the last three years, investors in search of yield have flocked to mortgage REITs due to the Federal Reserve's ultra easy interest rate policy. While I outline the rationale below, in short, I think investors should add to positions in mortgage REITs with the unease over interest rate policy.
Mortgage REITs take advantage of a tax status to invest in mortgage related real estate assets. REITs can invest in both physical real estate assets and real-estate related securities like mortgage-backed securities. REITs electing the take advantage of the tax status must distribute 90% of taxable income as dividends.
Mortgage REIT Business Model
A mortgage REIT's principal business objective is to generate income for distribution to its stockholders from the spread between the interest income received on its mortgage-backed securities and the cost of borrowing to finance its acquisition of mortgage-backed securities. In addition, most mortgage REITs utilize significant leverage to boost shareholder returns.
Despite the markets misgivings over interest rate policy and the modest rise in the 10 year Treasury I believe a diversified approach to mortgage REITs remains appropriate. Rates are unlikely to shoot higher in the near term due to significant macroeconomic and geopolitical headwinds.
- Stubbornly high unemployment;
- Ongoing European debt crisis;
- Slowdown in China;
- Backlog of foreclosed homes pressuring price;
- Uncertainty surrounding tax policy; and
- Uncertainty created by the general election.
Understanding the Risks
Mortgage REIT investors must assess interest rate risk and prepayment risk. Mortgage REITs are highly levered investment vehicles that are sensitive to rises in short-term in interest rates. With a borrow short, lend long business model a rise in short-term rates can impact profitability. In addition, mortgage refinancing damage securities that trade for more than face value by returning principal faster at par and curbing interest.
Interest Rate Risk
Due a weak economic outlook and stubbornly high unemployment rates, interest rates will likely remain low for quite some time. Despite comments this week about a lack of additional easing, any future increases in interest rates will likely be well telegraphed by the Federal Reserve and beyond 2014.
Prepayment Risks
According to eMBS prepayment rates have stabilized at a higher level over the last few months. The chart below outlines the increase in prepayment rates for agency mortgage back securities.
(click to enlarge)
While higher interest rates are unlikely to pose a real risk in the next few years, investors should closely monitor prepayment speeds. Mortgage REIT investors should focus on conditional prepayment rates (CPR) to monitor the health and dividend potential for mortgage REITs. The CPR reflects the percentage of principal that is prepaid over a period of time on an annualized basis.
As CPRs increase, the company will have to invest in securities with lower coupons, which will hurt earnings. Mortgage REITs are highly levered investment vehicles, which employ significant leverage to generate yields.
Recommendations:
I recommend that investors focus on a diversified pool or agency and non-agency mortgage REITs. While deploying the same basic borrow short, lend long thesis, M REIT strategies can vary. Annaly and American Capital Agency are agency REITs that are focused on fixed rate securities while MFA and Two Harbors are hybrid REITs that invest in distressed non-agencies and agencies.
Annaly Capital Management, Inc. (NLY) - Fixed Rate Agency Focused REIT
Price to Book Value: 1.0x
Dividend Yield: 14.0%
Market Capitalization: $15.2 billion
Leverage: 5.2x
American Capital Agency (AGNC) - Fixed Rate Agency Focused REIT
Price to Book Value: 1.1x
Dividend Yield: 16.7%
Market Capitalization: $9.0 billion
Leverage: 7.7x
MFA Financial (MFA) - Hybrid REIT (Agency and Non-Agency)
Price to Book Value: 1.0x
Dividend Yield: 13.3%
Market Capitalization: $2.6 billion
Leverage: 3.2x
Two Harbors (TWO) - Hybrid REIT (Agency and Non-Agency)
Price to Book Value: 1.1x
Dividend Yield: 15.9%
Market Capitalization: $2.1 billion
Leverage: 4.5x
Hatteras Financial (HTS) - Floating Rate Agency Focused REIT
Price to Book Value: 1.0x
Dividend Yield: 12.7%
Market Capitalization: $2.7 billion
Leverage: 6.7x
