2 mREITs To Buy And 3 I'd Avoid

by: Todd Johnson

Non agency mortgage real estate investment trusts (mREIT) offer dividend investors up to a 16.4% dividend yield. Non agency mREITs are also known as hybrid mREITs. These mREITs can invest in mortgage backed securities backed by the Federal Government and securities not guaranteed by the Federal Government. Prior to investing in a hybrid mREIT, investors should consider the risk tolerance and valuation of each security. Assuming appropriate asset allocation is used, dividend investors can obtain dividend yields of 16% and higher.

Two Harbors Investment Corp (NYSE:TWO)

Overview: Two Harbors is a hybrid mREIT founded in 2009 to acquire and manage a portfolio of residential mortgage backed securities. The mREIT is externally managed by Pine River Capital L.P. Two Harbors did raise capital in January 2012. These funds were invested in value added mortgage backed securities.

Residential mortgage backed securities valuations are driven by credit and default risk for non agency securities. Agency securities do not have credit risk due to the Federal Government guarantee. Two Harbors aims to manage prepayment, credit, policy risks and deliver superior returns to its investors.

Business Strategy: Pine River Capital L.P. 's goal is to create value for Two Harbors shareholders. The strategy is to successfully identify and capitalize on opportunities by dynamically allocating its capital between agency and non agency residential mortgage backed securities.

Two Harbors aims to benefit from its disciplined asset selection approach, which involves a rigorous analysis of the underlying loan quality, default and prepayment risks, and price attractiveness. Pine River Capital L.P. hedges its risks using proprietary strategies and by diversifying its residential mortgage backed investments across varying maturities such as 30 year fixed, 15 year fixed, home equity conversion mortgages, and adjustable rate mortgages.

Financials: Two Harbors reported 4th quarter earnings of 32 cents. The company earned $1.66 in 2011 Generally Accepted Accounting Principles (GAAP) earnings. Two Harbors derives its income from its management of agency and non agency mortgage backed securities. Two Harbors expenses are primarily management fees, general and administrative costs and income tax.

Dividends: Two Harbors pays out a quarterly dividend of 40 cents per share, or $1.60 per year. With shares trading at $9.87 as of February 14th, the annual dividend yield is 16.4%.

In October 2011, the Board approved a plan to repurchase 10 million shares of common stock. In addition, the company announced a SEC 424B5 filing to sell 25 million shares. Shares were sold in January of 2012.

Shares: In October 2011, the Board approved a plan to repurchase 10 million shares of common stock. In addition, the company announced a SEC 424B5 filing to sell 25 million shares. Shares were sold in January of 2012.

Peer Group: Peers include Chimera Investment Corporation (NYSE:CIM), Invesco Mortgage Capital (NYSE:IVR), American Capital Mortgage (NASDAQ:MTGE), and AG Mortgage Investment Trust (NYSE:MITT).

Chimera Investment Corporation

Chimera is a hybrid mREIT that is externally managed by Annaly's FIDAC unit.

The company has a $2.9 billion market capitalization. FIDAC's specialty is analyzing residential mortgage loans, commercial mortgage loans and securities, and fixed income opportunities.

I would recommend shareholders avoid Chimera due to the significant losses shareholders have experienced over the past 5 years. The above graph tells a financially embarrassing story.

Invesco Mortgage Capital

Invesco is a hybrid mREIT. The book value per share was $16.47 as of September 30th. The book value was $20.49 on December 31st, 2010. This is a material financial loss to shareholders. The fourth quarter book value per share will be announced on February 23rd.

As the below dividend chart indicates, investors may want to wait until February 23rd to determine if Invesco meets their income objectives.

I would avoid this stock due to the capital losses management has caused for shareholders.

American Capital Mortgage

Gary Kain manages the agency mortgage backed securities at American Capital Mortgage. Mr. Kain managed the mREIT to increase its book value from $19.96 on September 30 to $20.87 on December 31st.

The stock has increased by 20% in recent weeks. The February 8th book value news gave some hop to the the stock price. The goal of mREITs is to increase book value per share and pay solid dividends. American Capital Mortgage is delivering where other mREITs are failing to deliver positive results.

I'd buy this mREIT close to book value per share. This mREIT is doing everything right.

AG Mortgage Investment Trust

AG Mortgage had its initial public offering in 2011. The hybrid mREIT had a successful secondary offering, as announced on February 9th. The secondary was priced at $19.00. Here are the dividends through present date:

The September 30th book value per share was $20.10. The shares are currently trading at $19.36. The fourth quarter book value data has not been reported as of February 14th. The mREIT appears to be performing fairly well, assuming the book value per share has continued to increase. The stock is trading at a 3.6% discount to the 3rd quarter's book value per share.

I believe AG Mortgage appears to be a buy based upon the trends in book value per share since starting to trade.

Two Harbors Summary: Two Harbors lost 41 cents per share in book value per share. The hybrid mREIT currently trades at a 9.3% premium to book value per share. The two key metrics I follow are the book value per share and premium or discount to book value per share. External manager Pine River Capital L.P. lost 41 cents for the 2011 time frame. As a hybrid mortgage investor, I have never made money by paying a 9.3% premium on a hybrid mREIT. Based upon the mREIT's loss of book value in 2011, the mREIT should trade at a discount.

The company's President was pleased with the 12.6% total return in 2011. The 12.6% includes the $1.60 in dividends and the 41 cent loss in book value per share. The issue of loss of book value was not highlighted in the February 7th discussion:

Hopefully the mREIT will continue to pay significant dividends and the book value will rebound in 2012. Since Pine River Capital L.P. personnel are well respected in the hybrid mREIT industry, they will continue to cherry pick non agency securities for pennies on the dollar. Ideally, this should result in an increase of book value per share.

I would avoid these shares due to the loss of book value per share in 2011. In addition, the stock is trading at close to a 10% premium to book value.

Disclosure: I am long MTGE, MITT.