mREITs: Using The Price-To-Book Ratio To Choose One

 |  Includes: AGNC, AMTG
by: Darren McCammon

Mortgage real estate investment trusts (mREITs) provide strong double digit yields. They also have low correlation to the S&P 500 (Annaly Capital Management's (NYSE:NLY) correlation since the year 2000 with the S&P500 = .037) helping to reduce the overall risk in a portfolio. This article will give a brief overview of mREITs then focus on what I feel is one of the more important ratios to consider when deciding which mREIT to buy, the price to book ratio (P/B).

MREITs gain equity through stock sales, leverage it via short term borrowing, then buy mortgage backed securities ((MBSs)) with these funds. They make money on the spread between the short term rates they borrow at and long term rates they collect from these mortgages (the spread). Since they are incorporated as a REIT, they must return at least 90% of their earnings back to the investor via dividends. The Great Recession has proved an ideal situation for these securities with most yielding between 12 and 18% since it began. The dividends however are taxed as income. When possible mREITs are best held in tax advantaged accounts such as an IRA or 401k.

A significant difference between the various mREITs is some buy only agency mortgage backed securities (agency MBS), others concentrate on mortgages not backed by a federal agency (non-agency MBS) and others purchase a mix of the two (hybrids). Agency MBSs are guaranteed against default by Freddie Mac, Fannie Mae and other government supported entities. Thus they have almost no default risk. Another difference in mREITs is some hold more adjustable rate mortgages (e.g. Hatteras Financial Corporation) than fixed rate. In a rising interest rate environment adjustable rate mortgages reduce risk as the mortgage payments eventually increase along with borrowing costs. Thus adjustable rate paper has lower long term interest rate risk but it also typically has a lower spread.

Yield is mostly a factor of how much leverage is employed and is also directly related to risk. It is not uncommon for an mREIT to be leveraged 5 to 8 times its equity. Generally the more leverage, the more yield you get paid but also the more risk you take on. Deciding how much leverage to employ and how much to hedge interest rate changes is management's main contribution and driver on performance.

Yield is very important, and the main reason most investors buy mREITs; however, the price of the stock verse its book value (P/B) is another key statistic the investor should consider when deciding which mREIT to purchase.

Normally agency only mREITs should have a higher P/B than hybrids. This is because non-agency paper has more risk of default. A P/B of 1.13 for an agency only mREIT (e.g. American Capital Agency Corporation) means you are paying a 13% premium to the current value of the MBS the company holds in order to get the dividend yield. If the mortgages underlying those MBS were refinanced, you would only get $1 for your $1.13 purchase price.

Conversely if the P/B is .9 (e.g. Apollo Residential Mortgage (NYSE:AMTG), 90% agency, 10% non-agency) a refinance would result in a gain of at least 10% (gain would actually be higher if the non-agency paper were held at less than par on the books). With Apollo Residential Mortgage you can think of it as getting all of the non-agency MBS for free. If all of it's non-agency paper completely defaulted, their P/B would be 1. They would still be valued at a lower P/B than American Capital Agency Corporation (NASDAQ:AGNC).

Apollo Residential Mortgage and American Capital Agency both currently offer a 15.4% yield at today's prices. However, because Apollo Residential Mortgage has a much lower P/B, it represents the better value. Were all of the non-agency paper at Apollo Residential Mortgage to become worthless, it would still carry a lower P/B than American Capital Agency.

Disclosure: I am long both Apollo Residential Mortgage (AMTG) and American Capital Agency (AGNC) as well as other MREIT's: CYS Investments (NYSE:CYS), Armour Residential REIT (NYSE:ARR), Hatteras Financial Corporation (NYSE:HTS) & Newcastle Investment Corporation (NYSE:NCT). In the next 72 hours, I have no plans to add to nor sell any of the mREIT holdings mentioned in this article.