Due to overwhelming requests, we have decided to expand our series on "Comparing REITs: The Winners and The Risks," to encompass a greater number of mREITs in the space. In part 1 ( Read Article), we looked specifically at American Capital Agency Corp (AGNC), ARMOUR Residential (ARR), Hatteras Financial (HTS), and Annaly Capital Management (NLY). In Part 2, as promised, we will analyze four additional REITs from the same perspective we looked at the mREITs in part 1. In part 2, we will cover American Capital Mortgage Investment Corp (MTGE), CYS Investments Inc (CYS), Anworth Mortgage Asset Corporation (ANH), and Capstead Mortgage Corporation (CMO). In addition, we have decided to extend the series to cover an additional 12 mortgage REITs so that readers can have a much broader perspective of the companies in the space, including the unique strategies each employs to generate returns and the risks each of them face in the current environment.
In Part 3, we will cover Chimera Investment Corporation (CIM), Two Harbors Investment Corp. (TWO), Invesco Mortgage Capital (IVR), and MFA Financial Inc (MFA). In Part 4, we will analyze Resource Capital Corporation (RSO), New York Mortgage Trust (NYMT), Apollo Residential Mortgage Inc (AMTG), and PennyMac Mortgage Investment Trust (PMT). Finally, In Part 5, we will perform the same analysis on Western Asset Mortgage Capital Corp (WMC), Arlington Asset Investment Corp (AI), AG Mortgage Investment Trust Inc (MITT), and Commonwealth REIT (CWH).
For those of you wondering how we decided on the order, it was a very simple process. Except for the mREITs in Part 2, which we had already mentioned we would cover, all other mREITs were ranked by the number of seeking alpha followers for each mREIT. The more popular mREIT, therefore, would be covered sooner than those with few followers. Also, since it does take us some time to go through the quarterly and annual filings to extract some of this information, we expect to complete each part in the series approximately one week (give or take a few days) after the previous one. Please be patient.
The Search for Income
As we mentioned in part 1, investors looking for income have had to expand their universe of possible investments to include non-traditional asset classes. And even though many investors have previously invested in REITs, there has been an increasing reliance on the dividends paid by REITs to provide investors with the income levels they desire. In fact, mortgage REITs pay some of the highest dividends of all of the REITs in the marketplace. But investors should take heed of the risks they are taking in order to generate those dividends, and which mREITs not only can continue to pay dividends, but are implementing strategies and risk management to mitigate the risks inherent in their strategies.
Yield vs. Net Interest Income
The yield an mREIT pays out is directly proportional to the net interest spread it generates on its investments and the amount of leverage they use to "multiply" that spread. The higher the leverage and higher the spread, the higher the yield that investors can expect to receive. So long as everything goes as planned, leverage can be good. But when something goes wrong, (like a rapid increase in interest rates, higher than anticipated defaults, increases in refinancing, etc. ) leverage can ruin an mREIT, and leave investors with a bad taste in their mouths. While some mREITs may manage leverage better than others, we first want to look at how much leverage an mREIT has.
In the table below, we see that while MTGE has the highest projected yield, it has the lowest amount of leverage among the group. Instead, MTGE generates a higher yield by taking advantage of the highest net interest spread at 2.12%. It doesn't have the highest asset yield nor the lowest funding cost, but the combination it has put together has enabled it to have the most beneficial spread of the group. Because of the higher net interest spread, it doesn't need to leverage as much. Compare MTGE with ANH, which has the lowest projected yield as 9.52% but still has leverage of 8 times. While ANH still has a high net interest spread, we will explain later how ANH's portfolio will affect its yield going forward. Capstead Mortgage, on the other hand, has the highest amount of leverage and the lowest net interest spread. We would argue at first glance that the only way it has been able to maintain its dividend at such high rates is through leverage. However, the assets in its portfolio are quite different from many of the other mREITs and its funding costs are quite low. And last but not least, CYS seems to have a moderate combination of leverage and net interest spread.
In an environment where interest rates continue to fall, prepayment risk can be extremely detrimental to an mREIT. As interest rates fall, more and more borrowers will refinance to take advantage of lower rates, and the mREIT will be forced to write down the assets on their portfolio by the amount of any premium it paid (And most assets are bought at a premium), in addition to having to reinvest those funds at lower rates. While some of the risk may be mitigated by lower borrowing costs, this dynamic usually results in much narrower spreads going forward. In the table above, for example, we could see that three out of four mREITs are projected to have lower dividend yields over the next 12 months, compared with the dividend yield over the previous 12 months.
Analyzing the mREITs to determine which ones are most vulnerable to prepayments can be quite tricky. For example, in falling interest rate environment, adjustable rate mortgage (ARM) borrowers are less likely to refinance, because their rate will be reset lower and lower as rates decline. However, once interest rates reach a bottom, and the probability of interest rate increases become more likely than additional decreases, borrowers with adjustable rate mortgages will refinance to lock in a fixed rate.
With that dynamic in mind, we could reason that the mREIT that may experience the highest level of prepayments would have a high proportion of ARMs. The table below indicates that CMO has a portfolio consisting of 99% ARMs while ANH has a portfolio with 80% in adjustable rate mortgages. Comparing the Constant Prepayment Rates (CPR) of these two mREITs with the peer group confirms our initial assumption. CMO had a CPR of 16%, while ANH was as high as 24%. Since we don't expect rates to fall much further, the rate of refinancing may continue to increase.
What stood out to us from the CPR data below, however, was that MTGE had only a 5% CPR even as its asset yield was near 3%. The reason for this is that MTGE has intentionally invested in MBSs with a very low probability of prepayments. For example, $4M out of its $5.7M portfolio of loans consist of HARP (Home Affordable Refinance Programs) loans. These are loans that have already been refinanced recently and therefore are less likely to be refinanced again. As for CYS, couldn't quite figure out why its prepayments were so high. We went back a couple of years to determine if perhaps its ARM holdings were higher at some point. And while we found that its ARM holdings decreased from about 33% to 22%, we didn't think that was compelling enough to explain the high CPR.
Interest Rate Changes
One of the most talked about risks related to any fixed income security is the possibility of unexpected or rapid rises in interest rates. As interest rates rise, the value of the MBSs held in the portfolios of mREITs will tend to decline, the same behavior applicable to a traditional fixed income security such as a corporate bond. In addition, the net interest spread expected by the mREIT may also be affected by an unexpected change in interest rates. For example, as interest rates rise, the cost of borrowing, because of its shorter term, will tend to increase faster than the asset yields available in the MBSs. So the net interest spread could suffer in the short-term if these risks aren't properly managed.
In the table below, we can see that most of the mREITs listed have either hedged or are otherwise not affected much by changes in interest rates. The one exception seems to be CYS, with a possible decrease in its portfolio value of 2% with a 75bps rise in interest rates. For Anworth and Capstead, the impact of interest rate changes will be minimal, primarily because of the high proportion of ARMs in each of their portfolios.
As we mentioned before, ANH has a projected yield that is substantially below its previous 12-month yield. This is because 29% of the ARMs in its portfolio will be resetting within a year. With interest rates lower today than when they originally invested in the MBSs they currently hold, the expected asset yield of its portfolio would be expected to decline and/or prepayments would cause it to reinvest at less favorable rates. Capstead, on the other hand, is in a very unique situation. With such a high proportion of ARMs in its portfolio, they may experience an increase in asset yields if, and it is a big if, its level of prepayments decline. However, even if prepayments do continue to trend higher, as more and more borrowers refinance, the effect on the asset yield for Capstead is marginal compared with other mREITs since the current average asset yield on its portfolio is only 2.03%.
The impact on net interest income is illustrated in the table below. A 1% increase in interest rates can be disastrous for all of these mREITs. While interest rates aren't expected to rise anytime soon, investors should be wary of the possible impact a sudden unexpected rise in interest rates will have on the yields these mREITs pay. After all, if net interest income falls 10-20%, the only way to maintain the dividend is to increase leverage. And only MTGE really has the flexibility to do so easily.
How Risks Affect Other Components of MBSs
We have just about covered the different components of the MBSs held in the portfolios of each of the mREITs featured in this article. The one component which we would elaborate on is the HARP loans that make up a majority of the portfolio for MTGE. HARP loans are not only loans that have recently been refinanced, but they also tend to be lower coupon and lower balance loans compared with more traditional loans. Lower coupon loans by definition are less likely to be refinanced. After all, if they're already at low rates, the marginal benefit to a borrower is minimal. In the case of lower balance loans, the cost of refinancing as a percent of the loan makes it too expensive.
As far which of these mREITs is the best managed, it is hard to argue with the operating expense ratios for MTGE, with a 0.05% OPEX to Assets ratio and a 0.46% OPEX to Equity ratio. As we illustrate in the table below, the rest of the mREITs have similar cost structures.
It is difficult to overlook an mREIT in this environment that is increasing its dividend. MTGE recently increased its dividend and now has an expected 12-month yield of 14%. We like the heavy proportion of HARP loans that minimize prepayment risk, the moderate amount of leveraging they are currently using, and a very attractive net interest spread of 2.12%. In our view, MTGE has quite a bit of flexibility due to its high net spread and lower relative leverage. In the event of any spread tightening, MTGE can increase leverage modestly to maintain its dividend without being overly leveraged compared with peers.
An Interesting Alternative
While the CPR and low asset yield are immediate concerns, we view CMO as comparable with investing in a floating rate note. We would however, remain very cautious on how it handles a constant prepayment rate that may continue to rise. Any allocation to CMO should be in small quantities and we would abandon ship at any sign that the dividend yield is falling too fast.
To read more about how to use REITs in your portfolio, read our previous article on Seeking Alpha (Read More)
Additional disclosure: I may go long additional stocks mentioned. (MTGE)