Non-Agency Mortgage REITs: Part 7 - Hybrids

by: Philip Mause

This series of articles serves to highlight an often neglected group of stocks -- those real estate investment trusts (REITs) which invest largely or at least significantly in non-agency loans and securities (NMREITs). This group of stocks tends to behave differently from the agency REITs because it is exposed to at least some default risk, which means its assets tend to earn higher interest rates. The group also tends to use less leverage than agency mortgage REITs. In Part 6, I provided links to the earlier articles.

Because recent Federal Reserve policies have adversely affected many pure agency REITs, negative articles have been written about "mortgage REITs" in general, and investor sentiment has become sour. These companies are truly different from agency mortgage REITs but the confusion may lead them to be underpriced. I still think there are opportunities in the sector, which is why I have written the series.

The term "hybrid" is often used to describe certain NMREITs. It is difficult to define exactly what a hybrid is, but I am generally using the term to include NMREITs, which also invest in agency mortgages and mortgage backed securities. There are several of these stocks and although the market has not been kind to agency mortgage REITs in the past year, these hybrids appear to have done better. Indeed, some are trading near 12 month highs. I think that the reason is that the improving real estate market has enhanced the value of their non-agency assets by reducing the danger of defaults and this enhancement has offset the problems created for agency loans and securities caused by lower interest rates.

This group of stocks provides an interesting opportunity for yield oriented investors. As with many stocks in the group, some of the financial statements verge on being impenetrable. Many of the companies use special purpose entities (SPEs) and superficially appear to have enormous amounts of balance sheet debt which, upon closer scrutiny, is not a concern because it is non-recourse to any assets of the company outside the SPE. I have included information concerning a new company which went public in May and should have been included in Part 1 dealing with newbies. It is not a hybrid but I felt that this was a good place to include it before winding up my comprehensive list of companies in the sector.

With respect to each company in the table, I have included the symbol, Friday's closing price, the current yield, and my estimate of the percentage of assets on the balance sheet which are not agency securities or agency mortgages. Balance sheet data is based on the most recent financial reports as filed at the SEC; price and yield are based on Yahoo Financial.

Price Yield Non-Agency %
MFA $8.96 8.9% 45%
NYMT $6.73 16% 30%
IVR $21.65 12% 25%
TWO $12.37 17.8% 27%
ACRE $17.32 5.8% 100%

MFA Financial (NYSE:MFA) is a true hybrid in the sense that it has a high percentage of non-agency assets. One attractive aspect of MFA appears to be that it carries its large portfolio of non-agency MBS at a very conservative book value as described in this article. This means that as loans are repaid and the amount realized is more than the book value, income is automatically generated. The problem is that the non-agency RMBS market has pretty much shut down and new RMBS securities are not being generated so that as the existing pool runs off as mortgages are repaid or paid down, there is less opportunity to reinvest.

New York Mortgage Trust (NASDAQ:NYMT) raised a significant amount of money this past summer and fall in secondary offerings and is increasing its asset base considerably. The secondary were priced at $6.70, $6.73, and $6.89 with the largest being at $6.89. Buyers at Friday's price are getting in at a slight discount to the average price in the secondary offerings. NYMT appears to be opportunistic. It has large SPEs which hold multi-family mortgages as assets and make its financial statements a bit confusing. I am including only NYMT's investment in the SPEs and not the entire value of the SPEs in making my calculation of 30%. In a recent conference call, NYMT estimated that, by expanding, it will reduce the percentage of its revenue devoted to operating costs by 50% - illustrating the point I tried to make in Part 6 of this series.

Invesco Mortgage (NYSE:IVR) is trading near its 12 month high. It went public in 2009 and so it is, in a sense, a newbie with limited exposure to Pre-Crash assets and liabilities. IVR has invested heavily in non-agency RMBS, and CMBS as well as individual residential and commercial mortgages as is described in more detail here. Since it entered the market after the Crash, it likely bought at substantial discounts. My impression is that the management has been flexible, looking for ways to take advantage of the disruptions in the market and the bargains they produce.

Two Harbors Investment (NYSE:TWO) is, like IVR, primarily in the agency market but it has opportunistically bought into the non-agency market. It is also near its 12 month high. I have done very well with this stock but I still would be a buyer at this level although I might be inclined to wait for a pull back. One interesting thing about this company is that it took over many of its foreclosed properties and rented them out. It recently spun off this rental operation in the form of Silver Bay Realty (NYSE:SBY). TWO retained nearly 18 million shares of SBY, which raised additional funds in the offering. SBY will become a residential equity company; its stock is up nicely since the December 2012 offering; this obviously provides another source of price appreciation for investors in TWO.

Ares Commerical Real Estate (NYSE:ACRE) just entered the market in May, 2012, and is really a commercial mortgage REIT, and not a hybrid, because it invests in office building and apartment building mortgages and not agency securities. I have only included it here because this is the last part of the series devoted to individual companies. It is too early to make much of a determination about ACRE's track record at lending into the commercial sector.

I have made a lot of money in TWO and I have done okay with IVR. These stocks demonstrate that investors do not have to limit their horizons to agency mortgage REITs but can find other, less interest rate sensitive opportunities in the mortgage REIT space. I would recommend any of these companies as part of a well diversified yield oriented portfolio.

Disclosure: I am long TWO, IVR. 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.