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A Critical Quarter for Mortgage REITs

A commenter recently asked me what are the major risks of investing in mortgage REITs and what signs should one watch for so they could exit before there was a significant share price decline? This is a subject of intense interest for Mortgage REIT investors who were surprised by the net operating losses reported for the quarter that ended June 30, 2012 by several popular mREITs including American Capital Agency (AGNC), Armour Residential REIT (ARR), and Annaly Capital Management (NLY) (see Mid-Year mREIT Review - Where Do We Go From Here?). Although these mREITs made up for net operating losses with gains on securities held for sale, the results indicate that for some favorite mREITs, the fundamental business strategy of earning income on yield spread did not succeed in the second quarter. Should these mREITs post a consecutive net operating loss in the third quarter, it could cause even the most faithful investors to reconsider their positions. The results provoked prophesies of doom and gloom for mREITs, without mention of the fact that many mREITs, such as Cypress Investments (CYS), Hatteras Financial (HTR), and American Capital Mortgage (MTGE), reported very impressive financial results. Rather than letting fear drive decisions, I recommend you focus on the facts that ultimately determine the value of your investments.

Mortgage REIT share prices are supported by earnings and relative value. In the short term, irrational exuberance may cause investors to bid the price of an issue higher than any reasonable future earnings expectation, just as unfounded fear and panic may cause investors to bid the price below the most conservative valuation of future earnings. Over the long term, investors will pay fair value for earnings and dividends. Income investors also make relative value decisions that weigh the income that an investment is expected to produce against alternative income investment opportunities. For several years, low-risk income investments like CDs and money market funds have paid essentially zero, forcing income investors to accept some risk in order to get any significant income at all. Mortgage REITs, which earn income from the yield spread on a leveraged portfolio of mortgage investments, have emerged as a very rewarding option for income investors. However, let me state for the record that over the past five years not every mREIT has rewarded its shareholders; some issues have suspended dividends, crashed, and burned. In these cases. there were early warning signs, buried in the quarterly financial reports, available to be discovered by smart, diligent investors.

A basic analysis of the facts in the financial statement provides more reliable information than a forward-looking article founded in speculation and loaded with emotion provoking prophesies of gloom and doom. You can set alerts and get email notifications of news about your mREIT investments so you can download and review the quarterly financial reports, called 10-Q reports, as soon as they are available. You can download the 10-Q report directly from the investor relations section of the company website, or through SeekingAlpha.com.

The following table lists my estimated dates when certain popular mREITs will release their third-quarter financial results:

Anticipated mREIT Reporting Dates, Third Quarter 2012

Company

Symbol

Estimated Reporting Date

Armour Residential REIT

ARR

October 31, 2012

American Capital Agency

AGNC

November 8, 2012

Annaly Capital Management

NLY

November 7, 2012

Starwood Property Trust

STWD

November 7, 2012

MFA Financial

MFA

November 7, 2012

Invesco Mortgage Capital

IVR

November 6, 2012

Two Harbors Investment

TWO

November 2, 2012

Hatteras Financial

HTS

October 31, 2012

CYS Investments

CYS

October 22, 2012

American Capital Mortgage Investment

MTGE

November 14, 2012

Apollo Residential Mortgage

AMTG

November 9, 2012

The Basics

There is an enormous amount of information in the 10-Q report that you can use to determine the condition of the company and how well management is is meeting its objectives. Here are a few basic things to review.

Locate the Income Statement in the financial statements section of the 10-Q. Near the bottom of the columns for the most recent quarter and the 2012 year-to-date, find the Earnings per common share and the Dividends declared per common share. Compare these amounts to determine whether the company earned more than it paid in dividends. It is also useful to look back to the 10-Q report for the previous quarter and compare the earnings and dividends for the three months ending June 30 to the results for the three months ending September 30.

If you are concerned about dilution or a return of capital used to support dividends, the Balance Sheet contains the information you need to determine the net asset value (book value) per common share. Some mREITs without preferred stock will report this number near the bottom of the balance sheet. You can easily calculate this value by dividing the amount of common shareholder's equity by the number of common shares issued and outstanding at period end. If the company is making money and not diluting shareholder equity, the book value per common share will increase each period.

The fund manager includes a very interesting commentary on the most recent financial results and a discussion of factors likely to affect future financial results. To see what management has to say about the past and the future, locate and read the section of the report called "Management's Discussion and Analysis."

Going forward we should understand that not all mREITs have the same ability to earn income in every economic environment, and that mREIT income opportunities change as the time and the economy evolve. Some mREITs, such as ARR and AGNC restrict their investments to government guaranteed residential mortgage backed securities (MBS) issued by agencies like Fannie Mae and Freddie Mac. Hybrid mREITs, such as MTGE and TWO have more flexibility to seek investment opportunities beyond the government guaranteed residential mortgage market, such as non-agency residential mortgages, sub-prime mortgages, and commercial mortgages and loans. As the Fed continues downward pressure on residential mortgages announced in its QE3 program, we believe that those mREITs with the flexibility to opportunistically seek income from diverse sources are more likely to report stable and growing income per share. While this may be a time for income investors to consider reallocation, we see no evidence that this is the end of the opportunity to make money with mortgage REIT investments.

Source: A Critical Quarter For Mortgage REITs