Desperately Seeking Yield Through Equities Redux: Part 3 - Non-Agency Mortgage REITs

by: Philip Mause

This section deals with REITs which invest largely in mortgages and mortgage backed securities not backed by a federal agency. I say "largely" because there are some "hybrid" mortgage REITs which invest in some agency mortgages and some non-agency mortgages and I include them in this sector. I have written a series of articles starting here dealing solely with non-agency mortgage REITs (NMRETs) because the group is large and diverse.

As a general matter, this sector has been impacted by defaults, the perception of default risk and associated losses and costs. In some case, NMREITs have taken over buildings and are now, at least in part, equity REITs. The sector was absolutely devastated by the Panic of 2008 and there were some incredible bargains as well as some companies that went under in the sector. As usual in this kind of situation, this created the opportunity to make a lot of money as many of the stocks were trading at deep discounts to net asset value (NAV) on the fear that they might not survive. All the trouble is not over yet, but the improvement in the economy and a greater investor appetite for risk has led to some very nice returns in this sector.

The table below provides the closing price on June 16, 2011, the date of the first article, Wednesday's closing price and the current yield for Chimera (NYSE:CIM), Redwood Trust (NYSE:RWT), Invesco Mortgage (NYSE:IVR), NorthStar Financial (NRF), Starwood Properties (NYSE:STWD), CreXus Financial (NYSE:CXS), Apollo Commerical (NYSE:ARI), and PMC Commercial (PCC). Prices are derived from Yahoo Financial; yields are based on most recent quarterly dividends per SEC filings and company press releases.

Price 6/16/11 Price 3/6/13 Yield
CIM $3.47 $3.10 11.8%
RWT $14.96 $20.77 5.4%
IVR $21.02 $20.66 12.4%
NRF $3.90 $9.11 8.0%
STWD $20.06 $27.75 6.3%
CXS $10.26 $13.34 9.6%
ARI $15.91 $17.05 9.3%
PCC $8.48 $7.05 6.8%

The table shows that the sector has generally rebounded nicely partly as a result of a more favorable "risk on" investment atmosphere. On the other hand, the recovery has not been universal and an investor in the sector should both:

  1. Be very knowledgeable about his or her holdings and
  2. Diversify to reduce the risk of picking a loser.

It appears that commercial real estate has stabilized and that most of the ticking time bombs have already exploded. There is a great deal of commercial mortgage debt to be refinanced in the next few years but the companies and this sector and the banks have recovered sufficient financial health so that a successful transition is likely.

The diverse price behavior of the stocks in the sector reflects a wide variety of strategies and asset mixes. To some extent, the easy money has been made as stocks like NRF traded up from deep discounts to net asset value . The sector still provides some interesting opportunities but deep discounts are available only on stocks with "warts and pimples." I go into these matters in much more detail in my series devoted to this sector.

STWD is a "new" (post-crash) NMREIT and is thus not exposed to pre-crash loans which went bad. It has grown to roughly $3.8 billion in assets and has become the largest company in the sector. I believe that it is a solid investment at this price but is not likely to produce bonanza returns from here. NRF has been one of my favorites and seems to have come through a difficult post-crash environment; I would still recommend it here. CIM has gone a while without filing financials and, in this sector, financial statements are really essential to figuring out value. CIM's problems are complicated by a delisting deadline imposed by the New York Stock Exchange. CIM is still trading on the exchange but could be delisted if financial statements are not filed. Previous deadlines for such filings have been extended. I have to say that I did well with some investments in BDC stocks which faced financial statement issues for a period of time - e.g., Kohlberg Capital (NASDAQ:KCAP) - but stocks in the NMREIT sector generally carry more leverage than BDCs so buying a stock like CIM without detailed and audited information about leverage, debt structure, asset quality, and other matters detailed in financial statements is risky.

PCC looked attractive to me because it was not very highly leveraged and trading at a discount to net asset value. It specializes in making SBA and other loans to hotels and motels. Unfortunately, it is also a relatively small company and recent cash flow has been eaten up by payments for a "strategic study." PCC may recover once it gets these costs behind it but I am a bit gun shy here.

RWT is a solid citizen in the sector and should perform nicely going forward. It specializes in jumbo mortgages too large for agency support and has had a solid track record in terms of credit quality. CXS has been subject to takeover bids - the latest from part owner Annaly Capital (NYSE:NLY). CXS has recently entered into an agreement to be taken over by NLY at $13 a share but the agreement provides that CXS shall have until March 16 to shop for a higher offer and shall continue to pay dividends until actually taken over. The $13 tends to put a floor under the stock and there may be upside.

IVR is another post-crash entrant into the sector; it is a "hybrid" in the sense that its asset mix is 50% agency backed mortgages and securities and 50% non-agency supported assets. It has a resourceful management which appears to be navigating the mortgage market nicely. ARI invests largely in AAA rated CMBS securities and uses a fair amount of leverage which makes sense considering the quality of its assets.

The stocks in this sector vary enormously in terms of asset mix, strategy and leverage and so each stock must be examined individually. The table above reveals that recent price performance has also varied enormously. I still think that this is a sector in which a careful investor can earn a very nice yield with a substantial "kicker" in the form of price appreciation.

For investors interested in the sector I strongly advise a review of my earlier series of articles as well as whatever other materials you can get. There is still a lot of money to be made in this sector but you must look before you leap because these are somewhat treacherous waters.

Disclosure: I am long NRF, PCC, CXS, IVR, NLY, KCAP. 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.