2 Alternative Options To Consider As Mortgage REIT Yields Face Prepayment Pressure

Includes: PENN, VZ
by: Matt Schilling

One of the most important concerns for many investors of Mortgage REITs deals with the concept of prepayments. When the number of prepayments increases, it causes somewhat of a domino effect as spreads, profits, and revenues all begin to shrink significantly. Given the fact that prepayments have been demonstrating a sharp increase during the third quarter, many investors are seeing an even sharper decline in spreads, profits and the precious high-yields of many of these securities in the coming months. Investors should note that since 2011, Annaly Capital (NYSE:NLY), American Capital (NASDAQ:AGNC), Chimera Investment (NYSE:CIM) and CYS Investments (NYSE:CYS) have all reduced their respected dividends multiple times as a result of the increase in prepayments.

According to Zvi Bar who recently wrote an article on the Mortgage REIT sector, "mortgage prepayment rates have hit their highest levels since before the subprime crash during the third-quarter, which was clearly fueled by homeowners continuing to refinance with borrowing costs hovering around historic lows". If all-time lows continue to be shattered and a continuous pattern is formed, the longevity and attractiveness of this sector could be short lived.

If such a pattern in prepayment behavior is sustained over the next 6 -12 months, where should Mortgage REIT investors turn? In a case like thi,s I'd begin to look for an inexpensive value play that offers investors a secondary income stream. That being said, there are two potential options I'm considering, and those options are telecom giant Verizon (NYSE:VZ) and gaming conglomerate Penn National (NASDAQ:PENN).

What are some of the reasons why I like Verizon at these levels? There are a few fundamental reasons why I'm attracted to the stock. For starters, the company currently yields 4.90% ($2.06) and trades at P/E ratio of 38.26 which outpaces direct competitor AT&T (NYSE:T) by a ratio of 1.25 to 1. Secondly-- and in the wake of multiple dividend decreases by such names as Annaly, American, Chimera, and CYS-- Verizon has actually bucked this trend and increased its dividend by an average of $0.017/share over the last five years. Lastly, and most importantly, Verizon is trading at a 7.12% discount to its 50 DMA and a 5.27% discount to its 200 DMA, and although many of the Mortgage REITs are also trading at a discount, ancillary catalysts such as the Federal Reserve's spending behavior aren't on the mind of investors.

Why should potential investors consider Penn National at these levels? For the simple fact that it too, is planning on becoming a traditional REIT. This move, which will return both cash and stock, has unlocked substantial value for both potential investors and existing shareholders. According the Wall Street Journal, "Shareholders will receive shares in the property company, which will receive around $450 million in rent from the operating company-around half of the operating company's projected cash flow, or earnings before interest, taxes, depreciation and amortization. It expects to pay out a special dividend of around $15.40 per share in cash and shares, as well as a regular dividend that it projects will be around $2.36 a share".

The yield potential is also something mREIT investors may find attractive. Penn National is currently priced at $48.23/share. If we subtract the special dividend of $15.40/share, we're left with a share price of $32.83. Given the new share price of $32.83 (or possibly even less at the time of the spin-off) and the proposed dividend of $2.36/share, I currently calculate a forward yield of 7.19%, which is roughly half of what many of the mortgage REITs are currently yielding.

Final Analysis

Potential investors looking to establish a position in the Mortgage REIT sector should begin to consider alternative options as prepayments have increased substantially over the past few quarters and could continue to do so for at least the next 12-24 months. I'd personally continue to avoid the sector until the Fed eases its buying of mortgage backed securities, because at some point many of the remaining Mortgage REITs could run out of cash trying to keep up. As an income investor, I think both Verizon and Penn National offer some of the best and most consistent dividends the market has offer, and as a result I'd look to establish a long position at these levels.

Disclosure: I am long VZ, PENN. 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.