Two Harbors Investment Corp.: An Overlooked mREIT Investment

| About: Two Harbors (TWO)

Two Harbors Investment Corp. (NYSE:TWO) is a hybrid real estate investment trust (REIT) that invests in residential mortgage-backed securities (RMBS), residential mortgage loans, residential real properties and other financial assets. As a hybrid REIT, TWO management has the opportunity and flexibility to evaluate opportunities across the Agency and non-Agency RMBS.

As a REIT the company has elected to be taxed as a REIT for U.S. federal income tax purposes. This tax status requires that TWO distribute at least 90 percent of REIT income to stockholders on an annual basis.

TWO is externally managed and advised by PRCM Advisers LLC, a wholly-owned subsidiary of Pine River Capital Management L.P. TWO management generates a 17.3% dividend yield and has generated a total return of 33.6% since October 2009.

What Makes TWO Interesting?

As opposed to peers such as Annaly Capital and American Capital Agency, TWO management has the flexibility to invest in both agency and non-agency securities. Purchased at the appropriate price, non-agency securities can offer REIT investors attractive risk adjusted returns and lower the volatility in a REIT portfolio.

Non-agency mortgages trade more like equity than credit as when the economy heals, recoveries increase. As the economy heals the market drives interest rates up which hurt agency securities. TWO has invested in down beat mortgage bonds including subprime.

click to enlarge images

Click to enlarge


Click to enlarge

Agency Securities vs. Non Agency or Hybrid Securities

Mortgage REIT managers typically focus on an agency or hybrid strategies. Agency REITs carry limited credit risk as securities are guaranteed by government sponsored entities. Agency REITs are subject to interest rate and refinance risk. As opposed to agency REITs, hybrid REITs invest in both agency and non-agency securities. Hybrid REIT managers have the flexibility to move between agency and non-agency securities to find the best risk/reward for shareholders. Purchased at the appropriate price, non-agency securities can offer REIT investors attractive risk adjusted returns and lower the volatility in a REIT portfolio. Non-agency mortgages trade more like equity than credit as when the economy heals, recoveries increase. As the economy heals the market drives interest rates up which hurt agency securities.

A Diversified Approach

Most mortgage REITs trade around book value. Instead of trying to pick a winner I advise investors to buy a broad, diversified portfolio of agency and hybrid mortgage REITs.

While deploying the same basic borrow short, lend long thesis, mREIT 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. Below I have outlined by favorite REITs. In my view you are buying managers that deploy a specific strategy.

Given that dividend yields are typically low to mid teens I advise a broad and diversified portfolio with your capital allocated to mREITs.

Annaly Capital Management, Inc. (NYSE: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 (NASDAQ: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 (NYSE: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 - Hybrid REIT (Agency and Non-Agency)

  • Price to Book Value: 1.1x
  • Dividend Yield: 17.3%%
  • Market Capitalization: $2.1 billion
  • Leverage: 4.5x

Hatteras Financial (NYSE:HTS) - Floating Rate Agency Focused REIT

  • Price to Book Value: 1.0x
  • Dividend Yield: 12.7%
  • Market Capitalization: $2.7 billion
  • Leverage: 6.7x

Disclosure: I am long NLY, TWO, MFA.