Ever been invited to a party, declined to attend, then found out that you missed one helluva of a good time? That's the way I've felt as I sat and watched the returns from mREITs over the years. Despite the available double digit payouts, I always thought there was a catch that I was missing in these uniquely structured entities. Unlike many, I knew the sector existed, but always passed on the opportunity mostly because I failed to do my due diligence, until recently.
While the way in which each of these businesses generates high levels of income is generally the same, namely the spread between asset yield and borrowing costs, there are definitive variations in portfolio composition, leverage, risk, and payout from one mREIT to the next. For instance,
American Capital Agency (AGNC), one of the best known pure agency mREITs investing in residential mortgage-backed securities (MBS), with a TTM yield of better than 15% on roughly 7.5X leverage, identified five specific risk factors endemic to its business in its latest 10-Q report, namely:
- Interest Rate
Despite this list of risks, the company's portfolio is guaranteed by government related entities, primarily Fannie Mae and Freddie Mac. While this obviously does not eliminate the potential for investment loss or portfolio disruption, it does mitigate the company's overall risk profile compared to mREITs that invest in non-agency paper.
Another mREIT, Crexus Investment Corp. (CXS), which operates in the commercial MBS market, and sports a TTM yield of roughly 11%, identified a similar listing of risks in its 10-Q including:
- Interest Rates, Interest Rate Effect on Net Interest Income, Interest Rate Effect on Fair Value, Interest Rate Caps, and Interest Rate Mismatch
Crexus, which is managed by FIDAC, a subsidiary of Annaly (NLY), invests in retail, industrial, lodging, self-storage, and other commercial property types. As of June 30, roughly 3/4 of the company's portfolio was invested in subordinate and mezzanine debt. Unlike AGNC, Crexus's portfolio is not guaranteed, thus its mention of credit as a risk factor in its business.
So we know that these businesses are exposed to a plethora of fundamental financial pitfalls and that they utilize varying amounts of leverage to bolster return. We also know that their double-digit yields exceed, by and large, the lowest rated junk debt and virtually all other REIT and equity payouts. So what is the market exactly telling us, risk-wise, as a result of these continued high yields and does it think the mREIT party is about to be raided? Below are the basic possibilities I thought about during my due diligence:
- The market is pricing in a severe equity breakdown in the group and views current yields as unsustainable. As a result of interest rate movement, normal market gyrations, or another unforeseen fundamental reason, investors believe yields could drop precipitously, prompting an equity sell off and substantial capital loss proposition.
- The market appreciates and understands the hazards endemic to mREITs, and finds current capital valuation and lofty yields appropriate for the group.
- The market is missing the boat here; investment risks are misunderstood, overblown and businesses will prosper in varying macroeconomic environments. Enterprise valuations are too low - stock prices should be significantly higher with accompanying payout yields much lower.
Join the Party, Maybe?
Common discourse tells us that whenever something seems too good to be true, it usually is. In this market, double digit yields, in the absence of severe risk, would seem too good to be true. So as I had somewhat thought for years I considered door #1 above the probable answer. However, these companies have been reaping success for many, many years, have paid substantial, albeit somewhat erratic dividends, and have current sell-side brokerage support. That, to me, opened the door to #2, and perhaps even door #3, and somewhat closed the door on #1.
While I still had reservations about what happens to mREITs in a rising rate environment, I was inclined to take a position in the group because my personal feeling is that the current macroeconomic, low, stable rate environment will persist for some time. As such, I figured that a rapidly rising rate environment, commonly perceived as one of the biggest potential disasters for the group, was years away. I also considered the other major risk factors, but saw the interest rate scenario as the major investment pitfall that could derail the entire group.
Crashing the Party
So I decided that taking an mREIT position was a worthwhile proposition. Then came the issue and decision whether to take a winger on one of the stocks that I spent time on including AGNC and CXS, another major player like Annaly, or perhaps a hybrid (agency, non-agency) issue like Two Harbors (TWO), American Capital Mortgage (MTGE), or a smaller agency like Hatteras (HTS). I also toyed with the idea of simplifying matters and buying an ETF like REM, the iShares mREIT fund, with a TTM yield of roughly 11 percent.
Because I desired only minimal exposure to the group, didn't want to buy a basket of several companies, and honestly didn't want to invest time into figuring whether to go with NLY opposed to AGNC, or TWO as opposed to something like MFA Financial (MFA), I opted for REM which exposes me to everything, but is skewed heavily toward agency mREITs. AGNC and CXS, the two equities I spent the most researching, do seem like worthwhile investments on their own in my view, but at this point I felt the ETF the better solution to my personal situation.
Looking closer at REM, it holds 29 mREITs, but concentrates 3/4 of its assets in ten issues, and nearly 40% in the two major agency plays:
Company % Weighting
|ANNALY CAPITAL MANAGEMENT IN||20.41%|
|AMERICAN CAPITAL AGENCY CORP||18.22%|
|TWO HARBORS INVESTMENT CORP||5.59%|
|CYS INVESTMENTS INC||4.71%|
|STARWOOD PROPERTY TRUST INC||4.59%|
|ARMOUR RESIDENTIAL REIT INC||4.56%|
|INVESCO MORTGAGE CAPITAL||4.50%|
|MFA FINANCIAL INC||4.25%|
|HATTERAS FINANCIAL CORP||4.00%|
|CHIMERA INVESTMENT CORP||3.91%|
I'd rather not be paying the 50 basis point fee, but I find that fair for the instant diversification and quick, simple exit I can make if door #1 happens to unexpectedly open up and the mREIT crowd dashes for the turnstiles. REM only holds 1.5% of assets in Crexus, so I may decide to make a separate equity investment there to up my commercial mREIT exposure, but for now, have not done so.
While I feel I may be a bit late to the mREIT shindig, if the current domestic macroeconomic situation remains stable, which I predict, then the liquor should continue to flow. However, given the obvious risks that gigantic yields generated by variably leveraged business models exude, I think it may be wise to enjoy the party sensibly, and not become overly intoxicated. No one likes a hangover.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.