Mid-year mREIT Review - Where Do We Go From Here?
Here is a mid-year analysis of seven popular Mortgage Real Estate Investment Trusts (mREITs) as of June 30, 2012. The mREITs are American Capital Agency Corp. (AGNC), Armour Residential REIT, Inc. (ARR), CYS Investments, Inc. (CYS), Hatteras Financial Corp. (HTS), Invesco Mortgage Capital Inc. (IVR), Annaly Capital Management, Inc. (NLY), and Two Harbors Investment Corp. (TWO).
The results are both encouraging and alarming. Read on and we will walk through the tables together.
Table 1 - Price and Yield for January 1 - June 30, 2012
50 - 50
80 - 20
Types - All but two of the mREITs in the table invest only in mortgage securities issued and guaranteed by an agency of the U.S. government such as FNMA. Agency mortgages feature lower yields than non-agency mortgages, also known as sub-prime. IVR and TWO invest in a combination of agency and non-agency mortgages, which provides them with higher yields with increased risk.
Share Price , Dividend, and Yield - Shareholders during the first half of the year were rewarded with both capital gains and generous dividends. No investors in these issues suffered share price declines. Investors were not put off by declining yields for all issues during the period, or by dividend reductions by AGNC, ARR, and NLY. Compared to the alternatives, the yield and risk of these issues remain very attractive to investors.
Table 2 - Book Value, Premium / Discount, Debt to Equity
Book Value - All reported increased book value per share of common stock during the period. IVR, ARR, and TWO reported impressive increases of 12.1%, 11.1%, and 10.0%, respectively.
Premium / Discount - All of the issues trade at prices greater than the book value, with TWO and AGNC commanded the highest share price premium at 17.4% and 15.8%.
Debt to Equity Ratio, Leverage and Risk - Debt to equity ratio is a measure of leverage. mREITs invest shareholder capital in mortgage securities that yield ~ 3.5% - 5%. In order to pay high yields, mREITs multiply the shareholder capital using short-term loans. The more they borrow, the more they multiply the difference between the short-term borrowing cost and the yield on mortgage securities (i.e. the yield spread). The debt to equity ratio reveals the extent of leverage utilized. Risk and leverage are directly related.
Not surprisingly, ARR, which pays the highest yield, had the highest leverage with a debt to equity ratio of 9.2. AGNC, CYS, and HTS are around 8, while NLY, IVR and TWO are lower. NLY uses a strategy of lower dividend yield and a more complex capital structure to operate with less leverage at 6.9. IVR and TWO invest in a combination of higher yielding non-agency mortgage securities and are therefore are able to produce competitive dividends with less leverage at 6.6 and 4.9.
Table 3 - Six Months Earnings and Payout Ratio
OCI / Share
Comprehensive Income / Share
Six Months Earnings and Payout Ratio - Net Income is the excess of revenue over expenses for the primary business activity of the entity, which is leveraging and investing raised capital in mortgage securities. Net Income is reported in our table as Earnings Per Share (EPS) based on the average number of shares of common stock outstanding during the 6 months ending June 30, 2012.
Payout Ratio - Payout ratio is the dividends paid during the period divided by the earnings per share. It answers the question whether the entity earned enough to fund the dividend payments. A payout ratio above 100% means the mREIT paid more in dividends than it earned in Net Income, which is exactly what occurred with most of these mREITs. However, most of these mREITs had another source of income during the period to help fund dividends.
Other Comprehensive Income (OCI) - mREIT investors need to understand Other Comprehensive Income (OCI) and Comprehensive Income, and how it is different from Net Income. As stated above, net income is the excess of revenue over expenses for the primary business activity of the entity. OCI is income generated from other than operating activities; for these mREITs OCI resulted from the increased market value during the period of securities held for sale. As mortgage rates decline, the market value of older mortgage securities with higher yield increase in value. At period end, the book value of securities held for sale was adjusted to market value, and the gain was reported as OCI in the Comprehensive Income section of the financial statement in accordance with generally accepted accounting principles. Comprehensive Income is the sum of Net Income and OCI.
All these mREITs enjoyed strong OCI during the period. The OCI provided an alternate source of income to support dividend payments and shareholder value.
Comprehensive Income per Share, and Comprehensive Income Payout Ratio - The final two columns in Table 3 show the result of adding the OCI to the Net Income to compute Comprehensive Income Per Share, and the Comprehensive Income Payout Ratio. On the basis of Comprehensive Income, Payout Ratios were below 100% for the six months ending June 30. Stated another way, for the six months ended June 30, these mREITs did not fund the dividend with shareholder capital - they funded their dividend payout with operating income and OCI.
Table 4 - Income and Payout Ratio for the Quarter Ended June 30, 2012
OCI / Share
Income / Share
Final Quarter Earnings and Payout Ratio - For the quarter ended June 30, there was a significant decline in net income generated from the spread of leveraged mortgage investments, with AGNC, ARR, and NLY reporting net operating losses. HTS, CYS, and IVR managed to generate net income for the quarter, but not enough to fund dividends. On the basis of Comprehensive Income, all except IVR managed to fund their dividend payout for the quarter.
In an era when money market interest is barely more than a hypothetical concept and bank CDs pay less than 1%, income investors are hungry for alternatives - but all higher-yielding alternatives come with increased risk. For the past few years, mREITs have attracted and rewarded investors with generous dividend payouts and increasing shareholder equity.
The second-quarter financial performance demonstrates that evolving economic conditions have created a challenging environment for these mREITs. In this environment of falling mortgage rates and increasing short-term borrowing rates, the mREIT business model that worked during the past few years worked poorly during the most recent quarter. Although the mREITs increased their book value during the period, their reliance on OCI is a different business strategy than using leveraged capital to buy mortgage securities and multiply the yield spread.
Going forward, mREIT managers need to evolve strategy to adapt to change. Investors should consider whether they have confidence that management of their favorite mREIT will find ways to mitigate risks and capitalize on opportunities in this evolving and uniquely challenging economy. The smartest and most experienced managers will be best able to find ways to adapt and prosper. As margins tighten and leverage increases, the cost of missteps may be very high. Investors with large positions may wish to consider hedging and diversification to limit risk.
Disclosure: I have short and long positions in NLY, ARR, and AGNC. I conducted the analysis and 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.
Additional Disclosure: I am long AGNC, NLY, ARR. 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.