3 Questions To Consider Before Establishing A Position In The Mortgage REIT Sector

Includes: AGNC, NLY
by: Matt Schilling

As an income driven investor, I find it very hard not to be attracted to many of the high yields the Mortgage REIT sector has to offer. For example, Annaly Capital (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), Chimera Investment (NYSE:CIM), Two Harbors (NYSE:TWO), Invesco Mortgage Capital (NYSE:IVR) and Resource Capital Corp (NYSE:RSO) all yield at least 12.50%. That being said, there are three questions investors should ask themselves before jumping head first into a position.

1. Will Investors Be the Ones to Benefit from Annaly Capital's Last Ditch Effort to Diversify?

Let's begin by discussing what some are calling a desperate move to diversify in the wake of the Federal Reserve's third round of quantitative easing. As many investors already know, the Federal Reserve is strengthening its role as pseudo-Mortgage REIT, since it plans on purchasing an additional $40 billion of mortgage-backed securities each month. In an effort to soften the blow of the Fed's activity, Annaly Capital announced that it had made a bid to purchase all of the of the outstanding shares of Crexus Investment (NYSE:CXS), a much smaller REIT focusing on the commercial real estate sector. This transaction would give Annaly the portion of Crexus that isn't already owned by the company. Under the terms of the deal, Annaly will pay $12.50/share for the roughly 67 million outstanding shares of Crexus which represents a 13% premium over Crexus's pre-announcement market value and a 5% premium over its most recently reported book value.

The good news is there are several benefits to consider in terms of Annaly's proposed acquisition of Crexus. Some of the benefits include the lowering of Annaly's leverage and borrowing costs in the short term as well as the increase of net interest margins in the long term. The bad news is Annaly may be the fact the company is spreading itself way too thin. It should be noted that Annaly has already set aside $1.5 billion for share buybacks, and earnings could continue to suffer as a result of the ever-tightening yield curve.

2. Is American Capital Agency's $500 Million Dollar Buyback Really Boosting Shareholder Value?

The second development out of the Mortgage REIT sector I'd like to examine is the recent share buyback plan initiated by American Capital Agency. AGNC is very similar in scope to industry counterpart Annaly Capital, since both companies invest in Agency Mortgage Backed Securities or MBSs, which technically do not possess a credit risk because they are backed by the US Government. That being said, on October 29th, American Capital Agency announced it would be buying back as much as $500 million dollars of its own stock. Normally such buybacks would boost share price and essentially add a premium to the current value of the company's stock.

According to a press release discussing the transaction the company stated that:

it would be its intent to only repurchase shares when the repurchase price is less than its estimate of the current net book value of a share of common stock. When AGNC purchases its stock at a discount to book value, it increases the per share book value of the remaining shares.

The concept itself looks great on paper, except for the fact shares have been trading down roughly 10.52% since the buyback was first announced. From a short-term perspective this really hasn't paid the greatest of dividends. The long-term perspective however is a bit more promising. Based on Tuesday's closing price of $29.58/share, AGNC is currently yielding 16.20% ($5.00) and trading at a 9.90% discount to the company's current book value per share of $32.51.

3. Will Mortgage REITs Continue To Maintain Double-Digit Yields Given Current Market Conditions?

If the Federal Reserve continues to act as a pseudo-Mortgage REIT, the sector as a whole could be headed for some serious trouble, and the yields of these firms will almost all face the chopping block in one way or another. I strongly believe that the behavior of Fed, which has already affected much of purchasing power and profitability many of the Mortgage REITs need in order to sustain such high payouts, could continue to be an obstacle for growth as long as QE3 is in effect. One of the most attractive variables from an investment perspective is obviously the double-digit yields many of the sector components possess, but if QE3 is prolonged with no end in sight, investors may want to consider alternative high-yielding options.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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