Dispelling the Myths of Discount To Book Value with mREITs
Before we get into the meat of this article, let's clarify for the record that in an investment decision-making process, nothing trumps understanding the actual portfolio that an mREIT holds, and knowing exactly how they are making money. Due diligence in this area trumps all other metrics. That is the best way to assess the risk of book value and dividend sustainability over time. That being said, we want to expose some of the widely held myths about Book Value as it relates to "value investing" in the mREIT sector.
There is a drumbeat of articles that talk about the "all-important book value" of mREITs, and whether or not the book value is stable or underpriced. Often, there are "buy" or "sell" recommendations made based on a perceived discount or premium to book value based on the price of the common shares. This all seems logical at first glance. However, in reality, it's a false perception of value and safety that drives investors to be compelled to allocate capital in what seems to be a "too good to be true" scenario that far too often ends up being what is called a "Value Trap." A "Value Trap" is a stock that seems like it's a great value based on its book and yield, but in the end leaves investors with less-than-expected, (and in some cases negative) returns. For years now the mREIT sector has been filled with what we believe have been "Value Traps," as reflected by the total net returns of many of these stocks.
Value and Volatility
It is understandable how a big discount to book value and a "juicy" dividend would make some mREITs appear to be compelling buys. However, it's a flawed metric if you are looking for portfolio stability and steady cash flow. I would like to offer two different metrics for analyzing mREITs:
1. Yield to Book Value - Yield to Book Value is a way to determine the efficiency of risk management within the company. If a company has a longer duration portfolio, their yield to book value should be higher than a company with a shorter duration. For example, American Capital Agency (NASDAQ:AGNC) and Annaly (NYSE:NLY) are primarily fixed rate longer duration business models, and as such should have a substantially higher Yield to Book Value than a company like Capstead Mortgage Corp. (NYSE:CMO) that strives to have a much shorter duration portfolio, and therefore would by nature provide lower, safer, more predictable yields.
To calculate the Yield to Book Value, use this formula:
2. Total Yield Beta (T.Y.B.) T.Y.B. is a way to place an objective measurement on what an investor can expect regarding risk, volatility, and stability of returns. In short, the higher the T.Y.B., the more risky the investment. A lower T.Y.B. indicates less volatility in the share price and actual quarter to quarter book value.
To calculate the T.Y.B, first determine the discount to book value (D.B.V.):
Once you have established the % D.B.V, use this formula to arrive at the Total Yield Beta:
After you have the T.Y.B. and Yield to Book, it is important to have comparable data from several stocks in the sector. Below is a list of Total Yield Beta calculations based on closing prices as of Thursday, July 2, 2015. We included all the most popular mREITs, such as AGNC, ARMOUR Residential REIT (NYSE:ARR), Anworth Mortgage Asset (NYSE:ANH), CYS Investments (NYSE:CYS), New York Mortgage Trust (NASDAQ:NYMT), and a few others:
* duration gap after hedges is 45-90 days, which points to a lower yield to book.
** These companies have much longer duration risk, and therefore should have higher Yield to Book numbers than they do, but are currently underperforming their risk profile.
So what can we learn from this study?
1. D.B.V. alone is the wrong metric to use when trying to determine value in the mREIT sector.
2. High T.Y.B. indicates a high-risk scenario for investors, indicating greater likelihood of share price declines, which can result in substantial negative total yields for shareholders, who bought under the false assumption of value. It is true, however, that a high T.Y.B. can offer greater opportunities for asset appreciation as well. A classic Risk/Reward scenario.
3. Lower T.Y.B. indicates that the portfolio of a particular mREIT is more stable, offering a greater chance for a higher total yield, and a more stable portfolio value scenario for investors.
4. Longer duration mREITs seem to trade at significantly larger discounts to book value than short duration mREITs. Ironically, their Yield to Book numbers are not very impressive at the moment as Net Interest Margins have narrowed.
Conclusion: If your investment goals are outsized returns assisted by asset appreciation and you are willing to take on 2 or 3 times the normal risk, a high T.Y.B. mREIT may be right for you. However it's important that you know ahead of time that just because an mREIT trades at a substantial D.B.V., that fact alone does NOT make it a "safe" investment. In fact, the historical evidence clearly shows that this is often not the case. Investing in a high T.Y.B. instrument is not an income investing strategy, it is a capital appreciation strategy that carries all the risks associated with that approach. In many respects, it can often trade like a distressed instrument rather than a value instrument. So don't be deceived into thinking a high D.B.V. equals value. Often, that is not the case.
If you are seeking cash flow and an income based approach, history shows that a low T.Y.B. is the proper choice to make.
Disclosure: I am/we are long CMO.
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.