In this article, I plan to discuss mortgage REITs. Under IRS rules, any REIT must pay at least 90% of its annual profits as dividends to shareholders. Mortgage REITs, in particular, are the highest yielding common REITs because unlike shopping center or health care REITs, mortgage REITs use high degrees of leverage to expand their controls of assets. Dividend yields of 15% and more are common in this era of near zero rate short term interest. But that is an aberration to historical levels. Over the past fifteen years, most mortgage REIT dividend yields have ranged from as low as 4% to as high as the levels of the past two years.
Annaly Capital Management (NLY) is among the larger Real Estate Investment Trusts around, and the best known among those specializing in mortgage related securities. Its business relies primarily on just two things; interest rate spreads, and leverage. Those trends-- at least the interest rate spread-- have been under pressure. Despite the Fed's commitment to keep short term interest rates-- hence Annaly's funding costs, at near zero percent-- longer term mortgage rates have been trending down as well the past few years, narrowing the spread.
What is worse going forward if the economy does indeed heat up, and longer term interest rates and inflation rear as well, the Fed would undoubtedly raise short term rates also. This is an interest rate spread cycle that peaked in about 2009, and we are now on the down side of it, which there is no escaping. Absent increasing leverage-- now just over 5x, there is no way for Annaly to maintain its dividend.
In the first quarter, I had expected Annaly to announce a dividend in the $0.51 to $0.53 cent range. It surprised by announcing a $0.55 dividend. No one buys a mortgage REIT for capital gains. But if the $0.55 dividend were to be maintained, it offers a dividend yield of 13%.
There are three distinct threats to Annaly's recent generous dividend history. First, due to leverage, the flattening of the yield curve can yield disastrous results for Annaly's dividend going forward. There will come a time, when short term interest rates actually exceed the rates on 30 year mortgages. The last time a similar inverted curve occurred, in 2005 - 2006, Annaly's dividend yield was lower than the average intermediate bond fund. Again, that situation will return some day.
Second, what about the increasing, government sponsored mortgage prepayment plans? Annaly buys large pools of agency backed loans, and some of those loans are bound to be affected by renewed efforts to restate terms to avoid foreclosures. Third, and somewhat related to the second, is that there are real concerns about the continued viability of the main source of Annaly's mortgage pools-- Fanny Mae (OTCQB:FNMA) and Freddy Mac (OTCQB:FMCC). Annaly discussed these issues, and other explicit risks to company's profits in its most recent 10K.
For the next several quarters, I am comfortable believing that Annaly will pay quarterly dividends at a rate well into double digit yields. But the moment I see the Fed shift its short term policy, I would run-- and not walk away from this issue. If there are wholesale, administrative or legislative changes impacting the mortgage market, all bets are off. I am not willing to make that sort of bet, and have no personal interest in Annaly.
While it makes some sense to diversify the types of mortgage REITs one owns, please be aware that the management team that runs Annaly also runs Chimera (CIM), also an agency REIT.
American Capital Agency (AGNC) is another agency mortgage REIT, and in my opinion, a better version of Annaly. It also invests in mortgage pass through certificates and collateralized mortgage obligations, nearly all of which have government or agency guarantees.
American Capital stands out to me due to the management of Malon Wilkus and Gary Kain. American Capital started in business in 2008, so never has had to deal with inverted yield curves. But taking advantage of the conditions of today, it has the yield at 16.5%. That means in just a little over four years, compounded the dividend return would equal the invested amount. It pays the higher yield because it is even more leveraged, at 7.6 x than Annaly is at 5.2x. Of course, who knows what financial conditions will be four years from now? Short term, long term, new legislation, who knows? For the next six to twelve months, I think that American Capital is the best bet for high returns in the mortgage REIT market arena.
One partial non-agency mortgage REIT to consider is MFA Financial (MFA). By partial non agency, I mean that MFA can, at its discretion, purchase relatively safer agency or relatively less safe non agency mortgage securities. If properly executed, MFA can pick the precise ratio of agency to non-agency assets to maximize yields on a risk adjusted basis. At year-end 2011, about 35% of MFA's holdings were non-agency. MFA is self-administered, and has been around since 1998, long enough to have seen all the various cycles of the interest rate curve.
At year end 2011, MFA's financial statement indicated the most conservative overall position among mortgage REITs, with a leverage ratio of just 3.2x. But its ability to "cherry pick" non-agency mortgages allows it a larger interest rate spread than pure agency REITs, allowing a current dividend yield of 13.2%. I believe it is important to diversify mortgage REITs, and MFA is a fine choice for exposure to non-agency REITs.