MREITs are loved by dividend chasing investors for their double-digit dividend yields. In fact, bullish mREIT articles outweigh bearish ones by far and bulls seem to be so preoccupied with reaffirming themselves that their investments are at the top of the world, that opinions to the contrary are usually discredited by an array of accusations ranging from lack of knowledge to blank stupidity. This range of aggressive and emotional reacting to an opposing investment thesis shows just how fragile bulls judge their own investment thesis to be. This overconfidence bias will eventually lead to losses that outweigh the dividends received through the distribution years of the zero-interest-period. A period unlikely to neither persist nor repeat for the foreseeable future. Yet, it is purely astounding how much confidence investors place on the distribution stream and how willing they are to extrapolate. Sophisticated investors should know full well, that rising funding costs will squeeze net interest margins and are a serious threat to mREIT investors. At a bare minimum, there should be consensus that dividends are cyclically still quite high and already are marking a downward trend, especially for industry heavyweight Annaly (NLY) or related Chimera (CIM) with a quarter-long record of continued dividend declines. It is much more likely that this trend continues as it is to reverse when the industry faces headwinds from rate hikes.
High dividend yields reflect the riskiness of the underlying business model. The majority of investors are lured into buying mREITs because of their dividends without really questioning the fundamental drivers and risks of the underlying business model. Contrary to the bullish consensus I believe high dividend yields are a red flag especially paired with payout ratios of over 100% which scream unsustainability. I agree with bulls that mREITs have been good investments since the FED's initiation of its lose monetary policy, but I disagree massively as to the prospects of mREITs going forward. Less sophisticated investors might get lured into these high-risk investments without really understanding what they are buying.
Margins, earnings and distributions will eventually come under severe pressure, which management of these companies have already signaled, both verbally and practically through reduced dividends. Investors should particularly stay away from these 3 highly-leveraged, high-risk investments as their stock prices are set to head south (and making great short candidates):
Industry heavyweight with a market cap of $16.4 billion. Quarterly distributions per share are down from $0.75 in Q4 2009 to $0.55 in Q1 2012 with good downside to $0.20-0.30 per share once interest increases are viewed more realistically by investors. In this case, the share price is going to go down making NLY a great short candidate.
The analyst community is bearish about mREITs. NLY has recently been downgraded by FBR Capital, RBC Capital and Compass Point. The Seeking Alpha community is overwhelmingly bullish about the stock.
In addition, EPS is down this year and the P/CF ratio screams overvaluation at 18x. The PEG ratio at 11 is not promising either. Although the stock pattern just broke the upper short-term trend canal, indicating a buy signal, I consider the stock overbought. NLY is priced for a correction and I am short NLY with a price target of $12.
Related to NLY with only a little over two years of distribution record of which the last five quarters were marked by declining dividends. Distributions decreased from $0.18 per share in Q3 2010 to $0.11 in Q1 2012. The trend is quite clear and investors can judge what happens to the stock price and dividends once interest rates really rise.
Just like I would like to see NLY chart pattern developing, CIM investors are beginning to face a new reality. The stock was being sold off heavily during the last week quoting below $2.30 at some point. Investors who are trading on chart patterns might find this stock interesting to short.
In addition, Barclays has just downgraded CIM in a series of bearish analyst notes about specific companies and the sector in general.
American Capital Agency (AGNC)
Big player in the mREIT industry with a market cap of over $10 billion. The dividend yield currently stands at around 15% and the stock marked a high of $34. I have written before that I am short AGNC after the release of the Q1 numbers. Contrary to what many believe a 52 week or all-time high is not a reason for me to go long but to go short. The marginal buyer is a momentum buyer who enters into the investment for the wrong reasons. My general outlined thesis is still valid in my opinion and I am going to add to my short AGNC position.
As can be seen in the following 1 year Chart AGNC ran way ahead of what its fundamentals would justify. Analysts expect slowing EPS growth which is way too optimistic in my opinion. I believe that AGNC's EPS is going to decline and EPS growth is going to be negative for the years ahead based on the interest rate cycle. Low P/E or P/B ratios are irrelevant to value mREITs, the dividend coverage ratio is much more important. Based on the underlying interest rate cycle, AGNC will run into constraints with its dividend coverage. NLY is already signaling this to the market, the other mREITs are sure to catch up.
Besides being critical of the above mentioned mREITs investors should be equally careful with Invesco Mortgage Capital (IVR), Armour Residential (ARR) and Hatteras (HTS). Investors should always remember that double digit dividend yields represent high risk and should realize that they are putting their entire principal at risk. Total loss of capital is a real possibility. The likely prospect going forward is that dividends are going to decrease as earnings are not sufficient enough to back these unsustainable high dividends. Double dividend yields are going to be a thing of the past for these mREITs. In fact, I assume nobody will talk about mREITs anymore in a few years time.