The Best Mortgage REITs To Buy Now

by: Parsimony Investment Research

We believe the U.S. is facing long-term structural issues that will lead to a prolonged period of uneven, sub-par growth. The unemployment and housing issues that we face will take years, not quarters, to resolve. Politicians and economists will debate whether we are in or going into recession, but 1%-2% real growth will feel like recession for most Americans, and will not improve unemployment levels.

An unintended consequence of the slow recovery has been an unprecedented low interest rate environment. With 10-year Treasury yields hovering around 2.0%, this low interest rate policy is hurting savers that are looking for safe and reasonable nominal yields.

That said, many investors have been forced to go up the risk curve in search of yield. Generally speaking, higher-yielding asset classes carry more risk. One asset class that investors have turned to are mortgage REITs.

Mortgage REIT Overview

Mortgage REITs take advantage of a tax status to invest in mortgage related real estate assets. REITs can invest in both physical real estate assets and real-estate related securities like mortgage-backed securities ("MBS"). REITs electing the take advantage of the tax status must distribute 90% of taxable income as dividends. The primary advantage of using the REIT tax designation is that these companies do not pay state or federal corporate taxes on dividends paid to investors. Instead, the taxes are paid by the REIT equity holders (investors).

A mortgage REIT's principal business objective is to generate income for distribution to its stockholders from the spread between the interest income received on its mortgage-backed securities and the cost of borrowing to finance its acquisition of mortgage-backed securities. In addition, most mREITs utilize leverage to boost shareholder returns.

As discussed above, the "new normal" of sub-par, uneven growth with structurally high unemployment will likely persist for years to come. We believe that this is an ideal environment for mortgage REITs, which benefit from a steep yield curve with low short-term funding costs.

Analyzing Mortgage REITs

Investors should look at several key metrics when comparing and analyzing mortgage REITs, including size (market cap), leverage profile, composition of investments (i.e., Agency vs. Non-Agency and Fixed vs. Floating Rates), and most importantly tenure and strength of the management team. All of these metrics can significantly affect the risk profile of a particular mREIT. The following table compares the key metrics for several of the largest mREITs.

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As shown in the table above, hybrid mREITs, which invest in a mix of agency and non-agency MBS (e.g., Chimera Corp. (NYSE:CIM) and MFA Financial (NYSE:MFA) ), tend to trade at a discount to agency-only mREITs. This is because agency mortgages are guaranteed by government-sponsored entities (implying limited credit risk). Conversely, non-agency securities do not carry a similar implied guarantee, making them inherently more risky due to the higher relative credit risk. As such, hybrid mREITs typically deploy less leverage than agency-only mREITs.

MREITs with a high concentration of fixed rate securities, like American Capital Agency (NASDAQ:AGNC) and Annaly Capital (NYSE:NLY), will likely perform better if interest rates remain low. Meanwhile mREITs with a high floating rate concentration, like Hatteras Financial (NYSE:HTS), Anworth Mortgage (NYSE:ANH), and Capstead Mortgage (NYSE:CMO), is best for investors concerned about rising interest rates in the near future.

The Best mREITs to Buy Now

We think agency REITs continue to offer investors the best risk-adjusted yield due to (1) limited credit risk, (2) a relatively steep yield curve, (3) slower expected prepayment speeds, and (4) an accommodative Fed that has a stated plan of maintaining short-term interest rates (biggest risk to mREITs) for nearly two more years (mid-2013). That said, we caution investors to watch interest rates and prepayment rates very closely if invested in the space.

We are long-time holders of Annaly and American Capital Agency, which continue to be our two favorite mREITs in the space. Please see the links below for further details.

Disclosure: I am long AGNC, NLY.