Whenever I get to talking about Agency mREITs (admittedly, such talks seldom occur), the conversation goes like this. I first explain that Agency mREITs sport dividend yields in the 10 - 15 percent range. This pricks up ears. Questions are asked and answered about the nature of Agency mREIT business. Finally someone says, "Well, Agency mREITs seem OK when you explain them, but their leverage seems too high and those dividend yields seem too good to be true."
This article addresses these concerns. But before I try to answer that, some preliminary background information is in order. An Agency mREIT is a real estate investment trust that invests primarily in mortgage-backed securities (MBSs) guaranteed by one of Fannie Mae, Freddie Mac, or Ginnie Mae (colloquially known as the "Agencies" of the US government). Such MBSs can be called "Agency MBSs." They are funded by pools of residential property mortgages that conform to Agency underwriting standards and are known as "Prime" mortgages.
The largest Agency mREITs are Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC). Other notable Agency mREITs include Hatteras Financial (NYSE:HTS), CYS Investments (NYSE:CYS), and Capstead Mortgage (NYSE:CMO).
An Agency mREIT operates by (1) obtaining capital from shareholders by way of stock offerings, (2) borrowing multiples more money in the form of repurchase agreements ("repos"), (3) using the capital and borrowed money to buy Agency MBS, and then (4) pledging the just purchased Agency MBS as collateral for the repos. The Agency mREITs profit is the spread between the interest it receives from holding Agency MBS and the interest it pays on the repos used to fund the purchase of the Agency MBS (the "net interest spread"), minus some operating expenses.
Because Agency mREITs typically borrow $6 - $10 for every $1 in capital (i.e.; employ 6X - 10X leverage), the net interest spread, typically 1 - 3 percent, is levered up considerably, resulting in a profit of 10 - 15 percent return on equity (RoE). Agency mREITs, like all REITs, are required to pay almost all of their earnings as dividends, so the dividend yield of a REIT ends-up being roughly equal to RoE over time.
Now that the preliminaries are finished, let's address the concerns.
Agency mREITs are levered-up 6X - 10X. That's a lot.
When one compares an Agency mREITs to bond mutual funds or bond ETFs, which typically do not employ leverage at all, it is obvious that Agency mREITs entail comparatively more leverage and thus more risk. However, Agency mREITs can also be compared to commercial banks, many of which have been in business for several decades. Let's do that. Here are leverage figures taken from some Agency mREITs and the largest banks.
Annaly Capital Management
American Capital Agency
Bank of America
As of June-end, 2012. Source: Company websites.
Isn't that interesting? Agency mREITs and commercial banks use similar degrees of leverage. Since the leverage ratio employed by Agency mREITs is similar to that of banks that have been in business for 50 - 150 years, perhaps the leverage ratio by itself does not indicate highly elevated risks.
10 - 15 percent dividend yields are suspiciously high.
It is true that 10 - 15 percent dividend yields are exceptionally high, which can lead to suspicions of something "too good to be true." However dividends are not the only way of receiving returns on an investment in a stock-there is also capital gain. Total Return is dividends plus capital gain. If the Total Return of Agency mREITs is somewhat close to the average of stocks in general, then an exceptionally high dividend yield taken by itself may not be so worrisome.
That indeed is the case. Agency mREITs pay virtually all of their earnings as dividends while Agency mREIT assets are exceptionally marketable and liquid, so investors have no expectation of retained earnings accumulating in Agency mREIT capital accounts while would-be liquidation costs are minimal. The net result is that the book-to-market ratio of Agency mREITs tends to hover around 1.0 and as a result Agency mREIT stock prices tend to move sideways under normal market conditions (i.e.; Agency mREIT beta is low), resulting in little capital gain/loss. Thus Agency mREIT total returns should consist almost entirely of dividends.
Let's again look at some numbers. Here is the total return expressed as the three year compound annual growth rate of stock price plus trailing 12 month dividend yield of closing prices as of June 29, 2012, of Agency mREITs and that of the market, represented by the SPDR S&P 500 ETF SPY.
Annaly Capital Management
American Capital Agency
SPDR S&P 500 ETF
Sources: Company websites and Yahoo Finance.
With the exception of American Capital Agency's spectacular performance, Agency mREIT total returns are similar to that of the market. Thus, because the exceptionally dividend yields of Agency mREITs are offset by lower capital gains, looking at dividend yields by themselves as a risk indicator can be misleading.
I hope that by providing some context around figures that appear startling when viewed in isolation, it should be clear that some of the common concerns about Agency mREITs are not as serious as one might expect at first glance.
On the other hand, many readers will notice that interest rate risk is not covered in this article, especially the common concern about Agency mREIT exposure to the shape of the yield curve. Interest rate risk is a complex subject and even if explained simply, worthy of its own dedicated article.