In the present low-interest rate environment, many income oriented investors must seek out higher-yielding equities to include in fixed income and greater portfolios. One option offering dividends that are significantly above average is the agency mortgage REIT.
Agency mortgage REITs possess very interesting advantages and risks that make them, in many ways, different from other REITs and most equities. Most REITs own and operate property. Mortgage REITs own mortgages on real estate assets rather than the property itself. Agency mortgage REITs are supposed to have portfolios made up exclusively or principally of residential mortgage backed securities, or RMBSs, insured by federal agencies.
An agency RMBS, as opposed to an MBS issued by a non-agency lender, comes with an agency guarantee and an implied U.S. government guarantee. These federal agencies' implied or quasi-government guarantees have, so far, been proven virtually as solid as any paper issued directly by the Treasury, with a few exceptions.
Below, listed in alphabetical order, are five of the largest publicly traded agency mortgage REITs: Annaly Capital Management, Inc. (NYSE:NLY), American Capital Agency Corp. (NASDAQ:AGNC), Capstead Mortgage Corp (NYSE:CMO), Cypress Sharpridge Investments (NYSE:CYS), Hatteras Financial Corp (NYSE:HTS). These five REITs all offer yields between 13 and 17 percent, meaning that each of their quarterly payouts are vastly superior to the total annual payout on a 10-year Treasury, which is now about two percent.
Agency Mortgage REIT Risks
One risk that agency RMBSs possess is that they are often prepaid. As borrowers default on agency-backed loans, the agencies must either pay on the defaulting borrower's behalf or buy out the mortgage, which is one method of prepayment. Prepayment will also occur when a borrower refinances their mortgage. At the end of 2011, prepayment rates for agency RMBSs were at approximately 10 percent.
Prepayments can have a volatile affect upon an agency mREIT's quarterly income, yield and asset valuation, because the formerly performing loan is replaced with cash. Getting cashed out of your investment is considerably better than a defaulting loan, but the transaction leaves the agency REIT absent a portion of their anticipated incoming income.
Generally, such prepayments take out an older, higher yielding RMBS and require the agency REIT to purchase a newer RMBS. Due to the recent downtrend in Treasury yields, corresponding agency RMBS yields have also fallen and the agency REITs must reinvest into either a new RMBS with an inferior yield to the prepaid one, or a still performing older RMBS that is trading at a premium.
Another risk to agency REITs comes in the form of potential regulatory changes. Washington has not yet developed a reasonable substitute to the current agency system that failed and required bailing out. Any future change to the industry could conceivably shut down this portion of the REIT industry, if the future supply of agency paper were eliminated, with prepayments continuing until the eventual extinction of agency paper.
Other regulatory concerns come in the form of potential changes to the status of mortgage REITs. Some have argued that because mortgage REITs do not own or manage property, but merely securities, that they should not be granted REIT status. Presently, such a change in status appears an insignificant concern, but the SEC has raised the question as to whether Rule 3a-7 of the Investment Company Act of 1940 should exclude mortgage REITs from having to comply with the requirements of the Act, and such future regulatory changes, though unlikely, are difficult to predict.
Another risk relating to agency mortgage REITs comes in the form of their use of leverage. These REITs obtain lofty yields through leveraging the spreads they obtain, based upon the difference between their borrowing costs and the payout obtained by the RMBSs that they hold.
Most agency REITs now have spreads somewhere between 1.5 and 2 percent, which they then leverage in order to reach a double digit return. Spreads have been declining, while leverage rates have stayed stable, meaning that the risk is staying the same, while the reward is reducing.
The current leverage rates for agency REITs are between five and eight times the equity of each REIT. With a two percent spread and eight times leverage, a portfolio would generate a 16 percent yield before administrative costs. If a highly levered mREIT gets caught on the wrong side of an interest rate spike, the effect to book value will be significant.
Rising interest rates will reduce the value of RMBSs, because their value must decline to a rate where their yield will meet the new, higher rate. Such potential future declines will be multiplied by the leverage used by the holder. If interest rates do increase, or when they do, many investors may then flee the mREIT industry.
Many current investors anticipate selling when they see this future need coming over the horizon, but several will likely be surprised by the speed at which rate increase could come, and the substantial leveraged changes that may then occur. The U.S. Federal Reserve has stated it expects to maintain a low Federal funds rate through 2014, but such expectations could change, as could the feds ability to control the rate.
Much like Cinderella, many investors believe they will have no problem leaving the agency REIT ball before the magic ends. One difference, though, is that this ball will be one where everyone attending will simultaneously run for the door. Additionally, at least Cinderella knew the magic would end at midnight, but here there is no definitive time when the magic will end.
REITs must distribute at least 90 percent of their taxable income in order to eliminate the need to pay income tax at the corporate level. Under the current tax laws, mortgage REIT dividends are taxed as ordinary income, like Treasuries, and not at the lower corporate dividend rate.
Opinions differ on this asset class, and the significance of the above-mentioned risks, but most agree the current yields are hard to beat. Additionally, because these REITs are taxed as ordinary income, many investors prefer holding mortgage REITs in tax-sheltered accounts.
Disclosure: I am long NLY.
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.