By Dhruv Gupta
There has been a substantial headwind for mortgage REITs (mREITs) lately, sentiment wise. Many analysts claim that the so called "unsustainable" dividends being paid out by many mortgage REITs, even leading ones such as Annaly Capital Management (NLY), and particularly Armour Residential REIT (ARR), are going to lead to bankruptcy, and ultimately, the demise of the funds.
The beauty of a sustainable REITs, however, is that they have enough in the reserve to ride out a few bad years. Remember that dividends are paid not out of earnings, but out of cash reserves.
Let's take a closer look at ARMOUR Residential. Apart from the fact that net income for the fund has nearly tripled in the most recent quarter (ended March 2012), reaching $65 million compared with the previous quarter's $21 million, the firm has also kept its cash from operations level at about $35 million, with cash per share currently around $1.54.
There is a potential fundamental headwind with the Federal Reserve aiming to flatten the yield curve. A flatter yield curve indicates that the perceived risk of a security with increasing time horizon is not higher than it is now. In other words, there is no real payoff for holding off on redemption for a longer period of time. I believe this negates the effect of a low interest rate environment, simply because investors will not aim to lock in their money for a longer period of time.
Mortgage REITs depend on the steepness of the yield curve to earn their living. If they can borrow large amounts at low rates, hoping to pay off after a long period of time, when interest rates will be higher, then they can make more money now. Still, even with that headwind, I believe ARMOUR Residential is one of the better REITs out there, both fundamentally and in terms of technical price factors.
ARMOUR Residential is among the highest dividend yielders at a whopping 17%. The industry average is still only around 3%, making this REIT one to own. In defense of ARMOUR overpaying dividends, consider this. The average industry payout ratio for REITs is still over 100%. Therefore, ARMOUR Residential is not the only one on the block risking its cash position.
In addition, ARMOUR Residential also has no long-term debt, and even with the substantially higher than average short-term debt, the company manages a current and quick ratio of 1.16 and 1.16, respectively. On nearly every margin metric, the REIT outperforms the rest of the industry in terms of averages, and is by far one of the best managed REITs out there. I prefer it to competitors such as American Capital Agency (AGNC), which has a relatively erratic earnings chart, with an over 200% jump in earnings for the most recent quarter, after a consistently poor 2011 financial year. American Capital Agency also has a really high debt-to-equity ratio compared with the industry average.
Here are some other interesting performance statistics that should put you at ease if you are thinking about REITs, and stop you if you are thinking about selling off your holding in ARMOUR Residential. The fund beats the industry average in virtually every respect, leading to revenue growth of 30% over 3 years, compared with just over 5% for competitors. Even Annaly Capital Management averages less than 25% revenue growth for the 5-year average, as does Capstead Mortgage (CMO) with just over 20%. Another example is Equity Residential (EQR). Not only does it have less than the industry average operating margin at under 30%, its revenue growth is a meager .2% over 3 years.
Not only that, Equity Residential has no earnings to speak of at the moment. In terms of general fundamentals, Equity Residential operates apartments, which being part of a rental portfolio, means that rents are likely to take a hit if people are not earning enough money. In fact, with low interest rates, people are more likely to buy if they have the money.
As such, ARMOUR Residential continues to be one of the top performing REITs today. The harsh reality is that every REIT is going through a tough time. ARMOUR seems to have outperformed its competitors and the market virtually every time. I urge investors to consider taking a position in ARMOUR now.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.