High Yield MLPs And mREITs Flashing Warning, Danger And Opportunity

by: Cliff Wachtel

Observations And Lessons From The Controversy And Volatility Surrounding Linn Energy (LINE), Annaly Capital Management (NYSE:NLY), And Kinder Morgan Energy Partners, L.P. (NYSE:KMP)

Over the past months there has been a noticeable spike in both the volatility and number of articles covering LINE, KMP, and NLY. Even a cursory review of what happened with each of these stocks reveals some telling warnings and opportunities for income investors.

The most recent chapter in this saga began last week with a bearish report on KMP, one of the most highly regarded MLPs, by 26 year-old analyst Kevin Kaiser of Hedgeye Risk Management LLC, who appears set on attacking the MLPs. They've been among the past decade's very best performing sectors in terms of both yield and price appreciation. The report has been widely criticized, but it has also been widely discussed.

Not only has the number of articles soared, but also the level of interest. Income investors, many very knowledgeable, comprise a significant part of seekingalpha.com's huge readership. So SA can serve as an effective informal barometer of what are the hot topics among income investors. Anyone monitoring seekingalpha.com's "Top Articles," (most popular) over the past months will have noticed that every week the list seems to include at least one article on these or similar MLPs or REITs. As of this writing the list contains not just one, but two, and arguably a three such articles.

Why, and what does it mean? Like my last article, this one is as much an attempt to solicit answers as to shed whatever light I can.

Background: Roots Of The Controversy And Volatility

In the case the two high-yielding MLPs, Linn Energy and Kinder Morgan Energy Partners, L.P. , the origins of their volatility have been very similar. Articles from professional analysts and/or financial journalists questioned the sustainability and growth rates of their cash distributions, and so concluded that their share or unit prices were materially overvalued.

Unlike the NLY and KMP, NLY's troubles were not company specific but rather more symptomatic of concerns about the mREIT sector as a whole stemming from the dawn of a new era of rising interest rates that would hit both their balance sheets and revenues.

Note how both NLY and a representative mREIT ETF, MORT, moved in the same direction. The ETF was not surprisingly a bit less volatile given its more diversified composition.

(Click to enlarge)

MORT, 1 year chart, via finance.yahoo.com

01 sep 221709

(Click to enlarge)

NLY, 1 year chart, via finance.yahoo.com

02 sep 221711

With the start of speculation about the Fed's tapering of QE and the accompanying spike in interest rates, markets began questioning the sustainability of the yields and share price. While there can material variations in the business models of the mREITs, as well as in their success at hedging interest rate risk, their basic business model is to fund purchases of relatively high yielding long term mortgages using leverage (borrowed money) at much lower short term rates and profiting on the difference, the rate spread. When rates start spiking higher, two bad things happen to mREITs:

  • Falling profits from falling rate spreads: The spread between short and long term rates shrinks, and along with it, mREIT profits. It may at times even reverse and bring operating losses.
  • Falling asset values and also possible further profit reductions: Rising long term rates mean falling value of their assets, long term mortgage-backed securities. These assets are pledged as collateral for the mREIT's short term borrowing. Therefore a sudden spike in rates and corresponding drop in the value of these securities can force mREITs to sell those assets at losses in order to meet margin calls from the lenders. That reduced asset base reduces profits that can be made on the short-long interest rate spread.

This is a simplified but useful explanation of why markets sold mREITs when rumors, then confirmation, of Fed tapering hit. Assuming constant or growing supply of US debt instruments, less demand from a big buyer like the Fed would drive down bond prices and thus drive up bond yields and the interest rates that are based on those yields.

NLY got an exceptional amount of attention mostly because it's one of the largest and most prominent names in the sector (ok, it also wasn't the best positioned mREIT for a period of spiking rates).

The Common Denominators

In sum, investors are struggling with how to value both MLPs and mREITs in general. The controversy surrounding LINE, KMP, and NLY is just a symptom of that deeper problem of how to get a reliable valuation of MLPs and mReits.

The source of the problem is that neither type of company is organized or valued in the same way as a traditional c-corporation. Instead, valuations of both MLPs and REITS depend heavily on non-GAAP (Generally Accepted Accounting Standards) measures of cash available for distribution rather than traditional metrics like P/E or earnings.

There are legitimate reasons for the use of these metrics, and for their lack of standardization. In brief, these include:

1. In essence both types of businesses have exceptionally high non-cash depreciation expenses. That means:

-- Assets are fully depreciated for tax purposes long before the end of their useful life. In other words, their expenses look higher than they really are.

-- Because actual cash expenses are a smaller part of their total expenses (relative to standard c-corps) traditional measures of net income understate their financial health and available cash for distribution.

2. Both are typically required to distribute available cash not needed for ongoing operations, like debt service, payrolls, and maintenance, for a given number of months into the future.

3. The variety of business models within the MLP and mREIT sector have thus far stymied efforts to standardize methods to measure the amount of cash that can be prudently distributed.

In sum, these firms are valued by the size, sustainability, and anticipated growth rate of their available cash flow that funds dividends or distributions.

Again I oversimplify because a full explanation of these issues would be beyond the scope and focus of this article.

The Warning: Too Much Faith-Based Investing

Rather than detail the pros and cons of current MLP and mREIT valuation practices, my point is that the drawn out controversy surrounding these stocks shows how investors are suffering from a lack of:

  • Financial statement transparency (not accidentally in the case of LINE, see here for details)
  • Analytical skills needed to pierce the opaque valuation veil
  • Widely recognized sources of reliable analysis to help investors fill that information and skill gap
  • Transparency about Fed interest rate policy.

Yield hungry investors have gone en masse into investments that they don't fully understand, and are relying on third parties (and Fed) guidance of questionable reliability.

In sum, faith-based investing.

The Danger

Masses of insufficiently informed investors who lack a clear understanding of what a stock is worth brings volatility and losses when negative surprises hit. They're at risk of losses from selling to soon or holding too long. Those lacking a clear picture and a plan can make otherwise conservative and methodical long term investors prone to the same kind of emotion driven decision making one sees with inexperienced short term traders.

The Opportunity

The opportunity in these conditions exists for:

  • The investors who understand when the market has oversold or overbought a given MLP or mREIT can obviously take advantage of the mispricing. For example they can either buy at better prices or simply sell covered calls when markets get too bullish. Similarly, even if they don't own the stock they can sell puts when markets get too bearish, earning both income and a chance to establish bargain priced positions.
  • The writers and advisers who can supply that clarity and get their message out have a huge chance to build audience.

Taper Uncertainty Compounds Volatility

Obviously the Fed's policy vacillations since last May have added another layer of uncertainty and volatility to financial markets in general, and to interest rate sensitive investments in particular. MLPs and mREITs are particularly vulnerable to Fed gyrations because:

  • Rising returns of supposedly lower risk treasury notes and bonds are believed to reduce demand for income stocks because they are seen as bond substitutes that now have increased competition from bonds. That's causing these to sell off when rates are believed to be rising.
  • Both MLPs and REITs are capital intensive and depend on external funding sources like debt to fund expansion. Rising rates means rising debt service costs, lower distributions, and thus lower stock or unit (in the case of MLPs) prices.

For reasons noted in the background section above, mREITs have been particularly vulnerable to swings in market perceptions of Fed policy given the exceptional vulnerability of their business model to rapid rate increases.

To avoid any confusion, let me clarify that mREITs can prosper when rates rise slowly. Interest rate spreads can hold steady or grow, and they avoid margin call-driven asset sales. Meanwhile their relatively high yields continue to attract investors. Should markets become convinced that the Fed has both the intent and ability to engineer a very gradual rise in rates, mREIT share prices would likely recover their pre-taper levels.

DISCLAIMER: Article is for informational purposes only and expresses only my personal opinion. I've no relationship with any of these companies nor am I paid by anyone to offer a specific opinion. Author long NLY, KMP.

Disclosure: I am long NLY, KMP. 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.