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In my previous article, I presented an analytical review of financial results of seven popular mREITs for the six months ending June 30, 2012. Several commenters asked for specific recommendations (just tell me what to do), so here they are.

Many of the mREITs we reviewed suffered falling yield spread income and relied on appreciation of portfolio securities to fund dividends and growth. The portfolio gains are in accordance with generally accepted accounting principles, but that is not the way mREITs were designed to make money, and it is not sustainable because it would require continuously falling mortgage interest rates. So, where do we go from here?

What are the other options?

If we are nervous about the financial results of our favorite mREITs, where else could we invest for similar income? High yield funds pay 7.5% - 10% or so, far below the 14% - 17% we have enjoyed in our mREITs. A few MLPs yield 15% - 20% but never without strings attached; I found none that I recommend as long-term income investments. If we look at individual company issues, we assume a whole new level of risk, as any company can get in trouble and take us down with them. Nevertheless, a perusal of available high yield preferred issues found the following candidates:

  • REVZP Revlon Inc., Series A 12.75% Preferred .........Yield 11.1%
  • TLSRP Telos Corp., 12% Cumul. Redeem Preferred ....Suspended
  • CBCRO Capitol Trust XII, 10.50% Trust Preferred .....Suspended

Things get dicey when yields are above 8%. The cumulative preferred issues of our favorite mREITs (ARR-A 8.25%, AGNCP 8.0%, NLY-A 7.875%) actually look better than the available high yield preferred stocks, which brings us back to the mREITs.

Back to the mREITs

During the past year, many mREITs reduced dividend amounts and I expect this trend to continue. Instead of the rich 14% - 18% yield we enjoyed last year, we could see yields fall to 10% - 14%, and net asset value growth slow or stop. In past periods of financial stress, a few REITs (none of the ones mentioned here) had major problems. MREIT investors should immediately scrutinize and react to the first hint of delayed financial reporting or restatements. Accounting mistakes are not allowed in this league.

The mREITs we reviewed fall into two categories: Agency mREITs that invest only in securities backed by government sponsored agencies (FNMA, FHLMC), and Hybrid mREITs that invest in a mixture of agency and non-agency securities. All have experienced declining income from yield spread as mortgage rates fell and borrowing costs have increased, to the point where several - American Capital Agency (AGNC), Armour Residential REIT (ARR), and Annaly Capital Management (NLY) - reported net operating losses for the quarter ending June 30. Falling mortgage rates and rising borrowing costs, factors beyond the control of mREIT managers, have undermined the efficiency of the mREIT business model. Agency mREITs, while not subject to losses due to defaults, have few options to increase portfolio yield. Hybrid mREITs are free to invest in higher yielding securities where they believe the opportunity justifies the risk.

Criteria

I based my recommendations on historical and recent financial performance, any particular unique strategy utilized, and my subjective confidence in the management team. I divided my recommendations into Agency, Hybrid, and an overall favorite.

Recommendations

Agency: CYS Investments, Inc. (CYS)

In the current challenging environment, CYS managed to sustain earnings from the primary business of leveraging the yield spread between the portfolio of mortgage securities and the short-term borrowings. They have been in business since 2006 and their market cap is $1.7B. Historically they have sometimes been outperformed by some other mREITs, but so far this year they made the right moves.

Runners up: Hatteras Financial (HTS), American Capital Agency, Armour Residential REIT

HTS also maintained net income during the quarter ended June 30. AGNC and ARR get the nod based on demonstrated management competence and the expectation that they will find a way to continue to reward shareholders.

Hybrid: American Capital Mortgage Investment Corp. (MTGE)

A relative newcomer, MTGE was formed in 2011 by the experienced and very successful management of American Capital Ltd. who also manage AGNC. For the six months ending June 30, MTGE provided shareholders with a dividend yield of 14.6% (annualized) and capital gains of 12.5%.

Runners up:

TWO Harbors Investment (TWO), Annaly Capital Management

TWO has delivered generally good results although with a few more ups and downs than would occur in the ideal mREIT. They reported continuing good results for the six months and quarter ending June 30. NLY, one of the largest and oldest mREITs, has a long history of successfully managing the trust and rewarding faithful shareholders.

Overall Top Recommendation: MTGE American Capital Mortgage Investment Corp.

I am very excited about the potential of the relatively unconstrained investment charter of this mREIT in the hands of the experienced and successful management team at American Capital. As stated in their prospectus:

Our objective is to provide attractive risk-adjusted returns to our stockholders over the long-term through a combination of dividends and net book value appreciation. In pursuing this objective, we rely on our Manager's expertise to construct and manage a diversified mortgage investment portfolio by identifying asset classes that, when properly financed and hedged, are designed to produce attractive returns across a variety of market conditions and economic cycles, considering the risks associated with owning such investments.

In my opinion, this is the optimal mREIT investment charter for the current economic environment. MTGE has come out of the blocks with a strong start. I expect them to continue to perform well as they adapt to challenges and capitalize on opportunities as we go forward in this unique economic environment.

Source: Mid-Year mREIT Review Part II: The Recommendations

Additional disclosure: I have long positions in AGNC, ARR, and NLY. I may initiate a position in MTGE during the next 72 hours.