Seeking Alpha
Long/short equity, value, hedge fund analyst, REITs
Profile| Send Message| ()  

Before we delve into the effects of quantitative easing, let us first examine how mREITs work. The company becomes a creditor either through acquisition of the interest in an existent loan or by originating a loan. This is financed using highly leveraged capital, and the spread between the company's rates on lending and borrowing creates their cashflows.

Since mREITs rely so heavily on capturing profits from interest rate spreads, quantitative easing has a direct and profound effect on their profitability. Specifically, we will be examining how various aspects of mREITs are qualitatively affected by a low interest rate environment.

1) Spreads: While lower interest rates reduce the percent lenders can competitively charge, it also affords cheaper financing of company debt. These offset such that its impact on spreads depends on the relative magnitude of each factor. As an example, we can look at this table from Annaly Capital Management's (NLY) second quarter 10-Q.

Time Period

Avg. Yield of Interest on Lending

Avg. Cost of Interest on Borrowings

Spread %

2nd Quarter 2012

3.04%

1.50%

1.54%

1st Quarter 2012

3.23%

1.52%

1.71%

Year Ended 12/31/12

3.70%

1.61%

2.09%

For Annaly, the theory holds true as the cost of borrowing decreased along with yield on lending. However, the rate of decline on yields far outpaced that of costs so we see the spread drop to a dismal 1.54%.

2) Refinancing: The low interest rates resultant from quantitative easing are providing the financial impetus to refinance and increasing property values are creating the ability to do so. Consequently, mREITs are experiencing painfully high rates of prepayment. In fact, Fannie Mae 2011 30-year 4.0% fixed rate loans have had the following constant prepayment rates (CPR).

January 2012

February 2012

March 2012

April 2012

May 2012

June 2012

13%

19%

21%

14%

15%

21%

Source: JP Morgan

Naturally, CPR is higher on bigger coupon loans. This puts mREITs in an awkward position as they must either accept lower yields or suffer costly prepayments. American Capital Agency (AGNC) has chosen the former as evidenced by this table from their 2Q12 10-Q.

Time Period

Avg. Base Coupon

Avg. Premium Amortization

Avg. Interest Income

CPR

2Q12

3.96%

1.23%

2.73%

10%

2Q11

4.55%

1.20%

3.35%

9%

Much like NLY, AGNC is experiencing vastly reduced spreads.

3) Delinquency: Fitch Ratings reported that U.S. CMBS delinquencies dropped slightly in September as compared to August (8.37% from 8.39%) making it the 4th consecutive monthly decline. While the difference so far is only marginal, logic would dictate that we will see loan compliance continue to improve. Loans of lower interest rates are simply easier for debtors to comply with.

Given how QE has and will continue to affect the sector, it seems wise to know which mREITs are best positioned. We can break the companies off into 2 categories: Those which purchase interest in loans from government agencies, and non-agency mREITs. While many of these companies have some of each, their portfolios are dominated by a particular category.

Agency mREITs

Company (ticker)

Market Capitalization

Annual Yield $

Annual Yield %

Anworth Mortgage Asset Corp (ANH)

$880mm

$0.60

9.55%

MFA Financial Inc. (MFA)

$2.94B

$0.84

10.24%

Annaly Capital Management

$15.65B

$2.00

12.47%

American Capital Agency

$11.26B

$5.00

15.14%

Since these companies tend to acquire interest in a loan at a premium, they are particularly susceptible to prepayment. When debtors of their loans refinance, not only are future interest revenues forgone, but the purchase price in excess of the mortgage's par value is lost. Consequently, the favorability of refinancing created by quantitative easing is wrecking their profit margins. In terms of reduced delinquencies, these companies are not able to derive much benefit as they are already protected due to the loans being backed by government agencies.

Non-Agency

Company (ticker)

Market Capitalization

Annual Yield $

Annual Yield %

Newcastle Investment Corp. (NCT)

$1.38B

$0.88

11.01%

Northstar Realty Finance (NRF)

$890mm

$0.64

9.67%

While the interest in agency-backed loans usually must be acquired at a premium, non-agency loans are typically bought at or below par.

  • In 2Q12 NCT purchased $182mm of non-agency RMBS at an average price of 67.4% of par. Already in 3Q it acquired $29mm more at 62.9% of par.
  • In 2012 NRF purchased $552mm of face value CRE Loans and CDO bonds for only $290mm.

Consequently, non-agency mREITs no longer have to worry about prepayment. In fact, for loans acquired significantly below par, prepayment creates immediate gains. However, since these companies do not have agency backing to protect them, delinquency becomes far more troubling. In the QE-forever environment which is lowering delinquency and raising CPR, the non-agency mREITs seem to have significant advantage over their agency counterparts. The logical argument is backed up by company performance, as both Newcastle and Northstar were able to raise their dividends in 2012, while all of the aforementioned agency mREITs have been forced to cut theirs.

As Investments

Does a competitive advantage over their peers make these companies compelling investments? Well, the strong performance is only one aspect, as we must also consider valuation.

Company

Market Price $

Price/Book

200 Day Moving Avg.

2Q12 Earnings (AFFO)

Newcastle Investment Corp.

$7.99

2.17

$7.12

$0.29

Northstar Realty Finance

$6.56

1.06

$5.61

$0.22

Newcastle

Solid earnings seem to justify the dividend increase, but more progress will need to be made for any further dividend growth. While a price to book over 2 is rather common among equity REITs, it is frighteningly high for an mREIT. Perhaps it could be justified by its relatively lower leverage, but for this type of company I feel safer buying closer to book value.

Northstar

Like NCT it securely covers the dividend, and I suspect NRF will be able to further increase its dividend by the end of the year. Having already made tremendous gains in the market it is not as great of a value as it once was, but there is still some upside here. A large and rising dividend could easily send its market price up to $7.25.

Disclosure: 2nd Market Capital and its affiliated accounts are long NRF. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. I am long NRF. 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.

Source: QE Forever Gives Non-Agency mREITs A Competitive Advantage Over Their Peers