Why Management Should Matter To mREIT Investors

by: William Packer

Mortgage REITs, the beasts of the fixed income world, have grown to enormous size and stature. They make up the bread and butter of many investors' yield orientated portfolios. They come in many symbols and websites, many with funny sounding names like Javelin Mortgage Investment Corp. (NYSE:JMI), as if I was investing in a spear while living in a world of projectile weaponry. Perhaps investing in the company at this particular juncture would be just as daunting. The company is, after all, following somewhat in the footsteps of management's prior company Bimini Capital Management (OTCQB:BMNM) and the sister company peer group underperformer, ARMOUR Residential REIT, Inc. (NYSE:ARR). The better performers include American Capital Mortgage Investment Corp. (NASDAQ:MTGE) and Two Harbors Investment Corp. (NYSE:TWO). They are strong choices for investors willing to accept both credit risk and some interest rate risk. However, as many investors know all too well, non-agency MBS has been a dangerous game of volatility and a play on the housing market. Look no further than Chimera Investment Corporation (NYSE:CIM), a hybrid mortgage REIT that actually survived the prior meltdown. Then again, it really is all about management's ability to protect and preserve the Net Asset Value of the company. A closer look into the situation reveals that Ellington Financial LLC (NYSE:EFC) not only survived the 2008 mess but thrived and has continued to generate strong economic returns. So where will your mortgage REIT be in two to five years? It is not so much a function of rates or the economic outlook. These are important factors, but not exactly the best indicator of performance.

Let's take a closer look into Javelin Mortgage Investment Corp. The company had its IPO back in October of 2012, near the height of the MBS bond distortion that was created by speculation around the QE3 program and its effects on continuing to bolster bond asset prices. During that same time, a peer hybrid mortgage REIT called American Capital Mortgage Investment Corp., was operating in the same economic and low-yield environment. The book value of our special spear-named friend was $19.74 per common share outstanding while MTGE's book value was $25.74 per common share. If you fast forward one year you will see that JMI's book value tumbled to $14.69, or 25.6% loss to shareholder's equity. During that same time, MTGE's book value fell to $22.37 (13.1%). Looking at the dividend of both companies, MTGE's dividend was reduced by 22% while JMI's dividend was reduced by 35%.

Obviously, not all MREITs are created equal. You are buying the management team - not just the underlying assets. Keep that in mind the next time you look at purchasing MREIT shares. The mortgage REIT business is a business of adaptation. In my personal opinion, management teams like JMI, have no business operating on 6x to 10x leverage. They do not have the necessary skill set to manage the risks of MBS, let alone the skill set to leverage a portfolio of MBS 6x to 10x over.

An even better example of performance would be that of ARR vs. American Capital Agency Corp. (NASDAQ:AGNC). ARR's book value has done nothing but decline since its IPO. NAV at ARR was $9.30 per common share at the end of the Q1 2010 and, now, as of Q3 2013 the NAV is $5.26 per common share. This means the company has lost nearly half of its NAV over the past few years. Now, compare that to AGNC, which grew NAV over the same period of time. AGNC's NAV was $22.91 at the end of Q1 2010 and then went to $25.27 as of Q3 2013 - an improvement just over 10%. MBS values, today, are not at the lows of 2009 like they were when ARR had its IPO, so despite capital appreciation in MBS over that four to five-year period of time, ARR actually lost Net Asset Value. How is that? Well, a big part of it is mismanagement, but another part of it has to do with the dilutive offerings, which are the issuance of shares below NAV. Issuing shares below NAV reduces the earnings power and taxable earnings per share, as well as the NAV per share. Their dilutive offerings consisted of both secondary public offerings and the use of The "Dividend Reinvestment Program" in which the company paid out newly minted shares, instead of cash, when investors were enrolled in the plan. It was a form of dilution at the expense of existing shareholders, while the company traded below NAV. It is my personal belief that ARR will ultimately trade below $1 within the next two to five years.

The key to success of investing in this sector is being able to identify the differences between management teams in this space and their ability to quickly adapt (or fail to adapt) to changing market conditions in order to correctly manage the risks associated with a leveraged portfolio of mortgage-backed securities.

Disclosure: I am long AGNC. 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.