Will The Drop In Net Interest Margins Negatively Affect The High Yielding mREIT Sector?

 |  Includes: AGNC, TWO
by: Matt Schilling

As yesterday's numbers demonstrated a significant drop (-7.9% week over week) in the number of mortgage applications from last week, I wanted to take some time and highlight something that should be of concern to any potential investor looking to establish a position in the mREIT sector.

When it comes to investing in a Real Estate Investment Trusts (REITs) some of the highest yielding REITs are actually part of a sub-sector called mortgage REITs (mREITs for short). These mREITs make money on the difference between the cost at which they borrow and the rate at which they lend. This difference, also known as the Net Interest Margin, is usually wider when interest rates are sustainably low and narrower when rates are sustainably high. In this article I wanted to focus on one particular catalyst relative to the mREIT sector as whole which potential investors should consider and that catalyst is the behavior of net interest margins and how such behavior will affect potential shareholders and investors.

Over the last few months investors have seen such spreads shrink and as a result the profitability of several mREITs has also diminished a bit. For example, Net Interest Margins fell at American Capital Agency Corp. (NASDAQ:AGNC) by 66 basis points quarter over quarter and Two Harbors Investment Corp. (NYSE:TWO) by a total of 30 basis points over the same period. Those numbers, in my opinion, are quite alarming for two reasons. If the Federal Reserve continues to maintain its current policy on the direction of rates with no indication of changing them during the second half of 2012 or first half of 2013, we could see Net Interest Margins continue to shrink even further. Secondly, if the spreads continue to diminish, it will without question directly affect the yields these companies currently possess and in turn deter many of the high-yield driven investors from creating a position or adding additional shares to their current position.

I happen to think both AGNC and TWO are great plays at current levels, even though the Net Interest Margin numbers for both companies are at the forefront of my concerns. Over the last 12 months AGNC has demonstrated excellent profit (87.94%) and operating margins (88.48%) as well as very decent returns on both equity (12.07%) and assets(1.31%). My biggest concern in terms of AGNC clearly comes in the form of Net Asset Margins, which have fallen 66 basis points quarter over quarter. If such a drop continues, we could see the company's current yield of 14.90% and dividend of $5.00/share drop to as low as $3.75/share or even under $3.00/share.

The same theory is true when it comes to TWO, though it may not be as drastic but the company's yield will almost certainly be affected. Over the last 12 months, TWO has also demonstrated excellent profit (83.65%) and operating margins (82.43%) as well as satisfactory returns on both assets (1.92%) and equity (11.81%). If the company continues to experience a drop in Net Interest Margin quarter over quarter and year over year we could eventually see TWO's current yield (15.80%) and dividend $1.60/share diminish by as much 15% to 20% in the next 24 months.

In conclusion, will the drop in a company's net interest margin negatively affect the high yields these mREITs currently possess? The answer is "yes," and such a negative catalyst needs to be considered by current shareholders and those looking to establish a position in either of these companies at current levels.

Disclosure: I am long AGNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.