So far, we have provided brief overviews of a dozen or so mortgage REITs. Our short list of favorites from Part 1 was American Capital Agency Corp (AGNC) and ARMOUR Residential (ARR). From Part 2, we favored American Capital Mortgage Investment Corp (MTGE), In Part 3, we highlighted Invesco Mortgage Capital (IVR) and Capstead Mortgage Corporation (CMO).
In this part of Comparing Mortgage REITs, we find some unique strategies compared to the mREITs we have covered in previous articles. Specifically, we will cover Resource Capital (RSO), New York Mortgage Trust (NYMT), Apollo Residential Mortgage (AMTG), and PennyMac (PMT).
The Search for Income
As we mentioned in part 1 (Read Article), 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 refinancings, 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 summarize some of the key return metrics for each of the mREITs we are covering in this article. New York Mortgage Trust has an excellent yield and it is expected to increase. But New York Mortgage invests primarily in distressed and credit sensitive assets such as CMBSs backed by multi-family properties. It is also highly leverage with a leverage ratio of 7 times. We also want to point out Apollo Residential, with a projected yield of 15.48%, primarily investing in fixed income MBSs and moderate leverage.
PennyMac Mortgage didn't really grab our attention. Not only does it have the lowest projected yield of the group we are analyzing, 32% of its portfolio is Non-Agency securities subject to credit risk and it is seeing more opportunities to invest in that space. On the positive side, it is not very leveraged so perhaps there is a nice enough cushion in the event of defaults.
And finally, Resource Capital, not to be forgotten, primarily invests in bank loans in addition to RMBSs, CMBSs, structured notes, mezzanine loans and other asset backed securities. Because of its limited exposure to MBSs, we decided to add it to our analysis nonetheless, and it does offer some diversity to an otherwise mortgage dominated bunch.
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, 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.
Analyzing the mREITs to determine which ones are most vulnerable to prepayments can be quite tricky. It really depends on whether interest rates are rising or falling, whether the mREIT holds more fixed rate versus adjustable rate MBS, and the general trend in housing sales, etc. For example, in a 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, which might be where we are now, borrowers with adjustable rate mortgages will refinance to lock in a fixed rate.
In our group of four mREITs, we found it difficult to adequately compare the CPR because, quite honestly, neither RSO nor PMT reported it in their 10-Qs. That's not to say it wasn't in there in some form, but deciphering the information provided was beyond the scope of the analysis we wanted to provide in this article and would not have been consistent with the data provided in previous articles. In addition, we understand that CPR may not be as relevant to Resource Capital because of its focus on bank loans while PennyMac, which provided the information, did so in a way that made it difficult to reconcile.
In any case, we can reasonably assume that the prepayment rate for NYMT will be the highest because of the makeup of its portfolio, which is primarily adjustable rate mortgages (ARMs). And while Resource Capital also had a high level of ARMs, this assumption does not necessarily apply to it because of its focus on bank loans, which are usually short-term in nature and are rolled over into new debt when it matures.
What is surprising is that AMTG has an almost 100% fixed rate securities portfolio and its CPR rate is a mere 3.6%. We would expect the level of prepayments to increase slightly from what we feel is an unsustainable level.
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.
Unfortunately, the group of mREITs we are evaluating don't necessarily report the information the same way a number of other mREITs do. In the tables below, we provide a summary of the impact of interest rate movements on both portfolio value and net interest income. As we mentioned earlier, the PennyMac information was presented in such a way that reconciling it to compare to other mREITs was beyond the scope of this article.
The most noteworthy data is that of New York Mortgage Trust. With a 1% rise in interest rates, its net interest income will rise by 27%. While we find this figure dubious, we can understand the basis of this impact, which is primarily due to the lower grade, adjustable rate characteristics of its portfolio. On the other hand, a 1% decline in interest rates would cause a 53% decrease in net interest income, primarily due to the probable increase in prepayments as well as the adjustable rates in its portfolio.
How Risks Affect Other Components of MBSs
The mREITs covered in this article tend to invest in lower quality assets than those we have covered in previous articles. Besides Apollo, the other three mREITs invested a considerable proportion of their portfolios in distressed and credit sensitive assets, Collateralized Loan Obligations, bank loans, CMBSs, structured notes, mezzanine loans, and other asset-backed securities. These types of investments introduce a greater risk of credit default than investments in Agency Securities with implied US Government backing. And while some of the assets may be senior to other debt issued by companies, they are issued by corporations and small businesses with less than investment grade ratings.
Operating expenses for this group are considerably higher than those of other mREITs. We expect this to be the case because of the nature of the investments that these mREITs make. Specifically, we are referring to Resource Capital, New York Mortgage Trust, and PennyMac, which invests in securities requiring a higher level of due diligence and monitoring than other mREITs, including Apollo.
This may come as a surprise, but when we made our decision on the favorite for the group, we were thinking of which mREIT would best fit in a portfolio consisting of our other mREIT favorites. The winner, because of its unique strategy and our favorable opinion of the specific asset class, is Resource Capital. We are very positive on the outlook for bank loans and we think Resource Capital is a great way to play that theme. It may not necessarily be an mREIT but it does employ a comparable strategy. It generates a spread over the cost of funding by investing in securities backed by expected periodic payments and a lump sum at maturity. If we didn't tell you it invested in bank loans, you might have thought it was a pure mortgage REIT.
Stay tuned for a portfolio strategy article that may serve as a guide to putting together a portfolio of mREITs that both provide attractive income but does so with the least risk possible.
To read more about how to use all types of REITs in your portfolio, read our previous article on Seeking Alpha (Read More)
Additional disclosure: May also invest in IVR and RSO