Performance Review: 7 Hybrid Mortgage REITs

by: Zvi Bar

Hybrid mortgage REITs are usually more diversified, but also present more risk, than agency mREITs. The agency mREITs only hold residential mortgage backed securities, RMBSs, that are backed by U.S. government agencies, while the hybrid mREITs also hold non-agency-backed RMBSs.

Most hybrid mREITs alco hold large positions in agency RMBSs, so they are often not truly non-agency mREITs. The non-agency RMBSs that these hybrid mREITs hold are exactly the type of mortgages that caused the financial crisis. Now, very few non-agency mortgages are being issued, so most hybrid mREITs have accumulated larger positions in agency debt. Still, most hold large, if not majority positions in non-agency debt.

Without the agency guarantee, non-agency debt tends to pay a higher interest rate and offer these REITs a larger spread than agency REITs. Of course, this higher return comes real default risk, which is significant in the present market. Alternatively, defaulting agency mortgage holders are backed by the government agencies, which generally buy out the mortgage. This transfers the default risk to prepayment risk, which is worse than a performing loan, but far better than an outright default.

Some non-agency debt is collateralized by the underlying property, while other debt is non-recourse. Non-agency REITs also employ differing levels of leverage and hedging techniques. All these issues add risk and uncertainty to the asset class. Several non-agency lenders used loose lending practices through the past decade, which caused a great deal of default and other systemic issues we now witness.

Types of Non-Agency Mortgages

Prime mortgages: High-quality mortgages that meet rigorous underwriting requirements, similar to those used for agency mortgages. Such loans are usually non-agency because the balances are above what Fannie and Freddie allow. Prime mortgage loans have historically carried low default risk because they are usually made to high-credit-quality borrowers.

Alternative-A (Alt-A) mortgages: Alt-A loans are usually provided to borrowers with average or above average credit scores, and have historically required looser loan documentation requirements and allowed larger loan sizes than under agency underwriting guidelines.

Option Adjustable Rate Mortgages (Option ARMs): Option ARMs are a specific hybrid type of Alt-A mortgage that has flexible repayment terms. Option ARM mortgages allow for interest-only payments and sometimes even less than interest due payments. The loan balance of an Option ARM can increase over time ("negative amortization," in lending jargon). Such loans are designed to start with an exceedingly below average rate of interest, usually called a "teaser rate," to attract borrowers.

Subprime: Subprime mortgages are provided to borrowers with low credit ratings due to poor or limited credit history. Subprime mortgages usually require minimal income and asset verification and carry high default risk. Lenders usually charge Subprime borrowers a higher than average interest rate.

Examples of Non-Agency REITs

Through screening I have identified several REITs that are largely invested in non-agency RMBS paper, though not necessarily exclusively or to a majority, depending on their present portfolio mix: Chimera Investment (NYSE:CIM), Dynex Capital (NYSE:DX), Invesco Mortgage Capital (NYSE:IVR), MFA Financial (NYSE:MFA), Redwood Trust (NYSE:RWT), Two Harbors Investment (NYSE:TWO) and Walter Investment Management (WAC). None have yet released an annual report for 2011. I have provided recent equity performance rates and current annual dividend rates based.

REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level. Under the current tax laws, mREIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate.

Because these REITs must give away so much income, they cannot grow through retaining and re-deploying earnings. As a result, these REITs often choose to place secondary offerings in order to raise capital and increase market valuation. Such actions can be either dilutive or accretive to actual share value depending on how productive the REIT is at using the acquired funds. This can also make the quarterly payout volatile.

Mortgage REITs continue to be one of the highest yielding options available to income-oriented investors. Nonetheless, due to their significant risks, exposure to mREITs should be limited to a reasonable percentage of a portfolio, based upon an investor's risk profile, time-horizon and other investments. Additionally, because mREIT dividends are taxed as regular income they are substantially better performing investments when held within tax deferred or exempt accounts.

Disclosure: I am long CIM.

Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.