I'd like to begin by asking the entire investment community one simple question. What would you do if you woke up one morning to find out that the physical value of the US dollar was currently being determined in a conference room, and in the process, all consumer transactions would be put on hold until the revaluation of the currency was conducted, and furthermore implemented? You'd probably freak out, call the bank, call a doctor, and eventually sit down on your couch and try and figure out what was happening. The good news is, that scenario in itself is just a hypothetical, and although it is something that has long affected many of our Western European counterparts, it's not anything I see happening anytime soon. The bad news is, the concept of revaluation isn't anything new, and for many of my fellow income driven investors, such a concept is at the forefront of a debate surrounding the Real Estate Investment Trust (REIT) sector.
At the center of the debate, is the concept of Eminent Domain, which according to Selena Maranjian, of the Motley Fool.com, was recently defined as, "the power by which the federal government may conceivably buy loans back from mREITs in order to restructure the loans and decrease the number of underwater loans out there". On paper, the concept of wiping out the underwater loans sounds like a good idea, except for the fact such humanitarian strategies don't exactly result in profits and tend to deter investors rather than attract them.
According to an article written by my fellow SA Contributor, Qineqt, "Mortgage REITs invest in long-term U.S. mortgage-backed securities and earn an interest rate on them. They get the required funding to invest in their asset portfolio by borrowing short term. They borrow funds using repurchase agreements. NLY earns the interest rate spread or margin between the interest it receives on its interest-yielding asset and the interest it pays on its interest bearing liabilities. The record low policy rate has been helping these REITs borrow funds at record low costs, enabling them to distribute elevated returns in the shape of dividend distributions to their shareholders".
As long as the Federal Reserve continues to stand pat in terms of interest rates, REITs will be able to sustain the level at which earnings, margins, and dividend payouts are currently at. If the Federal Reserve decides to raise interest rates (although highly unlikely) 0.25% or even 0.50% in the next 12 months we could very well a sell-off in companies such as Chimera Investment Corp. (NYSE:CIM), Annaly Capital Management (NYSE:NLY), American Capital Agency (NASDAQ:AGNC) and Capstead Mortgage Corp. (NYSE:CMO) because they are so dependent on the spreads of such rates. Investors should keep in mind that an increase in rates will result in a decrease of revenue, and if a steep decline in revenue occurs the dividends of these firms will be directly affected. One thing investors should note is the fact that, all four of the mREITs referenced have decreased their respective dividends at least once in the last 12 months and a result of previous QE measures.
How will QE3 affect the mREIT sector? As most of the investment community has learned during the first two rounds of quantitative easing, programs such as Operation Twist and the Maturity Extension Program initiate the steps needed to hinder long-term interest rates directly affecting the mREIT sector. This time around, the Fed is intending to complete a purchase of as much as $40 billion dollars' worth of mortgage backed securities to restructure and reformat those securities in an effort to bring borrowers back above water.
My fellow SA Contributor Qineqt also noted in the same article that "through the third round of easing, the Fed aims to bring down mortgage rates. This will have a similar impact of depressing the interest rate spreads that these companies earn". The more the Fed intends on lowering interest rates the less of a chance these mREITs have at surviving, which equates into less of a chance potential investors have when it comes to taking advantage of some of the higher yields within the sector.
Why should Eminent Domain be considered the worst possible scenario when it comes to the mREIT sector? There are two reasons to consider the concept of Eminent Domain as the worst possible scenario for the mREIT sector. First, if someone said to you, "I have every intention of purchasing $40 billion dollars of mortgage backed securities, but before I do I'd like to restructure every last one so that when you get them back they aren't worth as much, and you'll be earning less interest on them", would you really say 'Yes"? I highly doubt it, but actions such as these demonstrate the ability the Federal Reserve has over the individual investors within the sector. To break the concept even smaller, it's like saying, "I know you bought that bottle of Coca-Cola for $1, but you know what, I'm really thirsty, so here's $0.50 and 'Thank You!'
The second reason why Eminent Domain should be considered the worst possible scenario for the sector is the fact that by dismantling the interest rate spread in an effort to satisfy the individual borrower and subsequently lowering rates, the Federal Reserve is going to almost instantaneously minimize the yields and dividend payouts of the REITs mentioned because the revenue that is generated through the rate spreads is now basically suffocating.
The concept of Eminent Domain is certainly not something those in the mREIT sector should take lightly, as the losses could eventually bring the sector (and firms within the sector) to a crippling halt. When it comes to establishing a position in the sector, I'd proceed with caution especially in terms of Annaly Capital (given the fact NLY has cut the dividend per share twice in the last 12 months), Chimera Investment (considering the fact the company's management team is similar scope to that of NLY's and cuts in the next 3-6 months wouldn't surprise me), American Capital Agency (a midsummer's downgrade by Wunderlich may indeed have predicted the short-term outlook on both AGNC and the sector as a whole) and lastly Capstead Mortgage (simply because the company's portfolio deals heavily in subprime mortgages and various derivatives associated with RMBS).
Disclosure: I am long CIM, 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.