The investment thesis for both agency and non-agency mortgage real estate investment trusts became even more compelling after Friday's global shock waves of a weak jobs report and slower growth from China.
As the Federal Reserve has focused on driving down interest rates to stimulate the economy, investors are on a search for yield. Mortgage REITs provide strong and attractive dividend yields in a low interest rate environment. The weak employment figures on Friday highlight the fact that the economic picture is very weak. We have structural employment issues that will take years to fix. Due to the focus on employment from the administration and Fed policy makers, I think investors can continue to own mortgage REITs. I believe that QE3 is coming in late summer. The Fed has discussed its dual mandate of price stability and full employment. Friday's report shows that the Fed is failing on its full employment mandate.
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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.
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.
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 damages securities that trade for more than face value by returning principal faster at par and curbing interest.
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. Lower rates are starting heal the housing market, but we will be at slow, stalled speed for years, keeping prepayments limited.
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Interest Rate Risk
Due a weak economic outlook and stubbornly high unemployment rates, interest rates will likely remain low for quite some time. Any future increases in interest rates will likely be well-telegraphed by the Federal Reserve and beyond 2014.
Prepayment Risks
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, 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.
Annaly Capital Management, Inc. (NLY) - Fixed Rate Agency Focused REIT
Price to Book Value: 1.0x
Dividend Yield: 13.2%
Market Capitalization: $15.9 billion
Leverage: 5.2x
American Capital Agency (AGNC) - Fixed Rate Agency Focused REIT
Price to Book Value: 1.1x
Dividend Yield: 15.3%
Market Capitalization: $9.8 billion
Leverage: 7.7x
MFA Financial (MFA) - Hybrid REIT (Agency and Non-Agency)
Price to Book Value: 1.0x
Dividend Yield: 12.6%
Market Capitalization: $2.7 billion
Leverage: 3.2x
Two Harbors (TWO) - Hybrid REIT (Agency and Non-Agency)
Price to Book Value: 1.1x
Dividend Yield: 15.5%
Market Capitalization: $2.1 billion
Leverage: 4.5x
Hatteras Financial (HTS) - Floating Rate Agency Focused REIT
Price to Book Value: 1.0x
Dividend Yield: 12.6%
Market Capitalization: $2.7 billion
Leverage: 6.7x
