Mortgage REITs: Risky With A Chance Of Dividend Cuts

by: Roger S. Conrad

The Bloomberg North American REIT Index is within a stone's throw of a new all-time high and yields 3.6 percent. At these levels, shares of mainstream real estate investment trusts (REIT) appear frothy: The index currently fetches 2.3 times book value, 6.1 times sales and more than 13 times annualized cash flow per share.

The run-up in the REIT space in part reflects a strong recovery in industry fundamentals after the 2008 credit crunch and the Great Recession. But a strong bid from income-starved investors in a low-yield environment has overextended valuations - especially when you consider that the quarterly dividends disbursed by many popular REITs have yet to recover to the levels that prevailed prior to the 2008-09 downturn.

In the current environment, bargains are few and far between. For example, shares of sale-leaseback financing specialist W.P. Carey (NYSE: WPC) have stalled out after soaring to a new high. Against this backdrop, you can understand why W.P. Carey insiders have been net sellers of the stock over the past six months.

Frothy valuations for REITs that hold real property have drawn some investors to a higher-yielding niche in the space: mortgage REITs (MREIT).

Whereas garden-variety REITs own real property and collect rents, MREITs hold real estate-related debt. The typical MREIT owns a portfolio of mortgage-backed securities, including mortgage pass-through certificates and collateralized mortgage obligations. Earnings and dividends depend on the spreads between these securities' yields and the cost of buying them and are augmented by leveraging or borrowing against the portfolio.

Recent developments have weighed heavily on the performance of MREITs. The Bloomberg REIT Mortgage Index has tumbled by almost 9.6 percent since hitting a five-year high on May 22, 2013.

Source: Bloomberg

Benchmark interest rates have climbed since the end of April 2013, with the yield on the 10-Year US Treasury peaking at 2.7 percent in early August. This recent uptick in Treasury yields reflects the increasing likelihood that the Federal Reserve will reduce its monthly bond purchases as the central bank gradually tightens its accommodative policies. (See Don't Fight the Fed-Listen to It.)

In turn, the prospect of rising interest rates has prompted investors to rotate out of fixed income, including the mortgage-backed securities held by MREITs. At the same time, the cost of borrowing to leverage portfolio returns has climbed, squeezing many MREITs' margins.

Although the uptick in mortgage rates has boosted current returns on securities recently purchased by MREITs, these higher yields haven't been sufficient to offset the margin squeeze or the declining value of the legacy mortgage-backed securities in their portfolios. MREITs' preference for longer-term paper in the low-yield environment of the past two years has exacerbated these problems.

The proof is in the dividends: A number of prominent M-REITs have slashed their payouts over the past 12 months, sending share prices spiraling lower.

Nevertheless, despite the recent pullback, stock prices in the space hover near levels that usually correspond to a market top. The key question for income-seeking investors is whether shares of M-REITs are merely finding a temporary trough within the context of an ongoing bull market. If the group's stock prices have indeed topped out, investors would do well to steer clear no matter how high the yields grow. However, if conditions in this niche space stabilize, now could be a good time for aggressive investors to take temporary positions in higher-quality names.

Although many income-seeking investors prefer the buy-and-hold approach, the volatile trading history of MREITs mean that these positions should be regarded as short term in nature. Bottom Line: You'll want to exit the MREIT space when conditions definitively turn for the negative.

Conservative investors would do well to avoid MREITs entirely - after four years of impressive gains, the current up-cycle appears to be petering out. These securities offer high yields, but their market action can be highly erratic.

MREITs' assets and liabilities are effectively a black box - management can dramatically change the complexion of the underlying portfolio between public filings.

Selectivity is Critical

Although looking at equity indexes helps to identify bigger-picture trends in the MREIT space, taking a granular approach to this group is essential to identifying the potential winners and steering clear of the losers.

When evaluating names in this space, the best clue to whether a particular stock has bottomed is the extent to which the recent uptick in interest rates has hit a MREIT's dividend and cash flow. Although we expect the Fed to phase out its accommodative policies gradually, a REIT that handled news of the central bank's plan to end quantitative easing with relative aplomb is likely a safer bet.

When evaluating MREITs, investors should pay particular attention to the following metrics.

  1. Dividend Coverage by Cash Flow (earnings factoring out balance sheet adjustments): An MREIT that managed to cover its payout despite the declining value of its underlying securities and an uptick in borrowing rates is in decent shape.
  2. Book Value per Share: Virtually all MREITs likely suffered a decline in book value during the second quarter. A big drop is cause for concern.
  3. Loss-Adjusted Yield on Portfolio Holdings/Net Interest Spreads: Investors should look for steadiness in these critical metrics.
  4. Projected Default and Prepayment Rates: The latter should be less of a risk now that mortgage rates have ticked up, reducing borrowers' incentive to refinance.

Although the inner workings of MREITs are as undiscernible to outsiders as what goes on at a mutual fund, these metrics provide a degree of insight into the near-term sustainability of their payouts.

Littered with Losers

American Capital Agency Corp's (NSDQ: AGNC) second-quarter loss of $2.37 per share actually beat the Bloomberg consensus estimate - that's the relatively good news. However, investors should be concerned about the 11.3 percent drop in the MREIT's book value during the quarter.

In American Capital Agency's earnings release, management cited "extreme volatility" as the reason that the company significantly reduced the size of its securities portfolio.

A prepayment rate of 10 percent was on par with the prior quarter but is still elevated. American Capital Agency's portfolio sported an average asset yield of 2.92 percent, which is higher than many of its peers. However, this metric and the MREITs income lag well behind the current payout.

Shares of American Capital Agency yield almost 19 percent for a reason - the ailing MREIT is likely to cut its dividend once again when it announces third-quarter results. Investors should avoid American Capital Agency, while current shareholders should liquidate their positions.

CapitalSource (NYSE: CSE) slashed its quarterly payout to $0.01 per share from $0.60 per share at the height of the financial crisis. Nevertheless, the stock has surged of late because of a proposed $2.3 billion merger with PacWest Bancorp (NSDQ: PACW), a California-based commercial bank. With most of the upside already priced into shares of CapitalSource, there's little upside for new investors.

Capstead Mortgage Corp (NYSE: CMO) lost only 2.1 percent of its book value in the second quarter, thanks to expense reductions and management's timely moves to pare its exposure to the hardest-hit segments of the mortgage-related securities market.

Still, the company's core earnings of $0.27 per share failed to cover the dividend of $0.31 per share. When you factor in elevated prepayment rates on the firm's existing holdings and management's emphasis on portfolio stability over growth, a dividend cut could be in the offing later this year.

Capstead Mortgage proved resilient throughout the credit crunch and Great Recession. But the stock rates a hold in the current environment because of the risk to the dividend. Investors shouldn't allocate additional capital to this name.

CYS Investments' (NYSE: CYS) second-quarter operating expenses averaged 0.98 percent of average net assets, up from 0.94 percent in the first three months of 2013. Despite the firm's focus on Treasury securities, its net-interest spread ticked up to 1.36 percent from 1.16 percent in the first quarter.

On the downside, the company's book value tumbled to $10.20 per share from about $12.87. With the dividend and stock price likely to remain under pressure as the Fed reins in quantitative easing and eventually raises the benchmark interest rate, CYS Investments is another name for investors to avoid and shareholders to sell.

The same goes for Hatteras Financial Corp (NYSE: HTR), which saw its net interest spread contract to 0.93 percent in the second quarter from 1.11 percent in the first three months of 2013. This headwind should reverse in the back half of the year, thanks to an overweight position in adjustable-rate agency securities (89.1 percent of its investment portfolio) and rising Treasury yields.

The company's book value per share plummeted to $22.18 from $28.18 during the quarter - an order of magnitude that should convince even the hardiest of investors to steer clear of this name. Hatteras Financial could be a major casualty when the Fed stops its bond-buying. Investors who own the stock should sell.

The Best of a Bad Bunch

Of the M-REITs that have reported second-quarter results, MFA Financial (NYSE: MFA) stands out, declaring a special dividend of $0.28 per share on top of its regular payout of $0.22 per share. The company's book value per share declined modestly to $8.29 in the second quarter from $8.84 at the end of March.

MFA Financial's loss-adjusted yield on its portfolio increased to 7.15 percent from the prior quarter's 6.8 percent. And its $1.265 billion credit reserve provides ample support for the $5.296 billion portfolio. Prepayment rates were flat relative to the first quarter.

Thus far, conservative portfolio management and a straightforward dividend policy have helped MFA Financial stand out in a niche that's better-known for its gun-slinging ways.

However, prospective investors must remember that MFA Financial relies heavily on leverage to bolster its dividend and that the value of its portfolio fluctuates with benchmark interest rates. As the stock's ultra-high yield indicates, this is still a risky name.

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.