It's hard to dispute that having your money in mREITs (Mortgage Real Estate Investment Trusts) has been a lucrative endeavor over the past few years (with a few exceptions, of course). Reaping huge dividends while interest rates are low is the name of the game in this arena, and the best players will need to know if a company is signaling a downward revision to its payouts.
It's anyone's guess where interest rates are headed, but there is a simple metric we employ to measure the risk of an upward or downward surprise in distributions in this red hot sector.
The crux of the MREIT business model is employing leverage to magnify an interest spread. An overly simplified example would be if you could borrow 5% and invest in a preferred stock that earned 6%, netting you 1% on your investment. Imagine now that your borrowing source allowed you to borrow five times as much as your initial investment. Your return has now ballooned to around 5%. Without delving into repurchase agreements and margin accounts, this is the general principle at hand.
Our metric takes an mREIT's net interest spread earned and multiplies it by the leverage employed to find the actual yield the company is generating at the time of disclosure (in this case, end of First Quarter 2012). We then multiply this yield by the book value to extrapolate an implied dividend (divided by four to generate an implied quarterly dividend). If the current actual dividend is substantially higher than this implied dividend, the risk of a downward revision increases. In this scenario, the company would either have to generate a capital gains component to make up for the shortfall in earnings or reduce its payout accordingly. It is generally not our intention to depend on capital gains as a dividend source and we invest accordingly.
Here is a breakdown of how eight popular mREITs measure up using this calculation:
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American Capital Agency Corp. (AGNC) stands out as the clear favorite, employing the largest leverage of the group. The rest range from nearly covered distributions to significantly deficient, specifically Hatteras Financial Corp. (HTS) and Annaly Capital Management (NLY). In fact, these companies, along with Anworth Mortgage Asset Corp. (ANH) have seen falling implied yields (leverage multiplied by net spread) over the past six quarters, primarily due to falling rates. By maintaining a steady leverage, their returns have been squeezed, and it appears that their dividends are at risk to fall in the near term.
Finally, it may have been a happy coincidence, but this model accurately predicts Anworth Mortgage's disappointing 2nd Quarter 18 cent dividend that was announced June 29th, using information obtained from their 1st Quarter results issued April 26th, 2012. The aforementioned 17.89 cent calculated dividend was almost exactly the revised amount. However, Hatteras Financial has since maintained its lofty 90 cent payout in spite of only generating an implied dividend of around 69 cents. Time will tell if its condition is as rosy as its distribution infers.
We encourage shareholders to employ this metric using the upcoming second quarter results to monitor the health of these companies. As for predicting secondaries, well you're definitely on your own on that.
Disclosure: I am long AGNC.
Additional disclosure: Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this report. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.