Lately, I've started to place more emphasis on working in evaluation of preferred shares for mREITs. I see this as a potentially very interesting area for investment because I think share pricing often suffers from some inefficiencies and those inefficiencies can be fairly substantial as demonstrated by the swings in share prices throughout the day. Of course, investors may remember January 20th for the common share market for mREITs falling about 10% and then rebounding by about 10%. Some mREITs ended up, others ended down, but the entire movement was incredible to watch.
Picking Some mREITs
I have a group of mREITs that I'm going to start with, but I'm happy to expand the pool to include more mREITs. Keep in mind this is strictly dealing with the preferred shares. The first mREITs on my list are:
Annaly Capital Management (NYSE:NLY)
American Capital Agency Corp. (NASDAQ:AGNC)
ARMOUR Residential REIT (NYSE:ARR)
CYS Investments (NYSE:CYS)
Dynex Capital (NYSE:DX)
American Capital Mortgage Investment (NASDAQ:MTGE)
New York Mortgage Trust (NASDAQ:NYMT)
I would like to get this list up to having about 10 to 15 mREITs on here, so feel free to make suggestions.
Why I'm Coming Back to Preferred Shares
I've done some research on the mREIT preferred shares before, but I'm coming back to it after spending some time studying Benjamin Graham's work. The common shares can be an excellent opportunity for doing thorough due diligence and coming up with a strong investment thesis. However, there is also a substantial amount of work that goes into learning what each mREIT holds and finding ways to simulate their portfolio.
It makes sense to leverage the understanding of the fundamental risks of each mREIT to analyze the risk of a bankruptcy event. While I don't think bankruptcy events are likely, they are the only scenario that is a major concern to me in the investment thesis. The yields on these preferred shares are ranging from just under 8% to around 9.4%.
The interesting thing about the current state of the mREIT industry is that the companies trade at a significant discount to book value for almost every mREIT. However, the discounts to par value are much more varied.
The Forest or the Trees
I believe each investor that truly wants to learn will need to take on the hard task of analyzing themselves and searching for their own weaknesses. When I participate in any kind of competitive event, I want to have a recording so I can analyze myself. Finding our own weaknesses and working on them is critical to improving as investors. Yet, this is an area that most people don't want to look at. They may look at the change in their portfolio value, but they are not likely to reassess their fundamental understanding of investments.
One of my challenges is seeing the forest rather than all the trees. When I'm analyzing mREITs, it can be fairly easy to get distracted in the tiny nuanced parts of the analysis. The ability to analyze the trees, rather than the forest, has been useful in finding pair trades that play out exceptionally well. However, that can make it easy to discount the analysis of the fundamental problems facing the mREIT industry. The simple challenge here is that the Federal Reserve wants to push short-term rates higher and doesn't seem too concerned about the problems they could cause by inverting the yield curve. On the other hand, for mREITs to really shine they need to have a steeper yield curve. Ideally, the industry would transition to that in a slow and controlled manner. In a more realistic scenario, the volatility levels will be high and produce significant problems. If the yield curve becomes steeper quickly, it will mean further book value losses, though the mREITs would be worthy of trading at smaller discounts.
Unfortunately, a smaller discount to a lower number (new book value) is not creating a case for excellent returns. It is making the case for very mediocre returns.
On the other hand, the preferred shares should mostly be exposed to the risk of a bankruptcy or liquidation. If the liquidation value is above the price paid, then the yield on the investment is even better if the security gets called away. Quite a few of these securities are trading at a discount to par value worth 1 to 2 years of dividends. Therefore, the idea of an orderly liquidation does not bother me. I would view that event as positive and take the substantial profits to search for new opportunities.
The Preferred Shares
I put together the following sheet with the closing values as of the Friday evening. The yields are rough because I'm not compounding them annually or worrying about what percentage of a quarter is left until the next payment. This brings me back to the point Graham made about the "margin of safety" on investments. If I can only justify the investment on the basis of the dividend date, then my margin of safety is weak.
On the other hand, if I can find a 9% yield with fairly low risk of bankruptcy and the potential for higher yield to be realized if liquidation happens to come through, then I have a fairly solid investment. In this case, the selection of securities is based on the margin of safety. Due to poor liquidity among some of the issues, I'll need to use historical pricing ranges to assist in determining what prices might be available. Once I know which securities I would want at which prices, I'll be able to compare that with the prices I think might be available on those securities so I can set up the "limit buy" orders. Due to a large bid-ask spread on some of the issues I'm considering, market orders would be extremely unwise.
Theoretically, an investor might simply identify the desirable prices for each security and set their orders accordingly, but I need to have actually cash available to fund the orders if they are executed. Therefore, I don't want to have open orders for every security on the basis that it might theoretically hit my bid.
The following chart shows the preferred shares I've looked into so far:
A Quick Note on Prices
I've grabbed closing values. The poor liquidity can cause a closing price to misrepresent the recent average price for shares. However, it is the most timely data available.
I've highlighted the A series for NLY because it concerns me that this issue is showing a slightly lower yield than the issues that have more "call protection" by having a call date in 2017. Since those two securities are trading over a dollar below par value, I imagine the shareholders would love to get called so they could take a premium to the share price and immediately reinvest in another similar security. All things considered, I would be quite surprised if NLY started calling in preferred shares when most mREIT preferred shares are trading below par value. However, it is feasible that an inversion of the yield curve could occur over the next few years or a substantial flattening that would draw in activists to push for liquidation. Since liquidation is possible within the next several years, getting a discount to par means a nice boost if the event happened.
I've highlighted AGNC's issue for a similar reason. They are trading above par value and have a yield below 8%. They are not exclusively agency anymore and they are known to dial up the risk when they feel it looks right. If the mREIT industry is so risky most issues should trade at major discounts to par, this probably shouldn't have such a nice premium.
NYMTP gets highlighted in orange. They have the highest yield, but they should have the highest yield. Their business is the riskiest on here by a significant margin, in my opinion. That additional risk demands additional yield and that additional yield needs to be present on both the preferred shares and the common.
Dynex Capital gets their issues highlighted in some shade of purple or lavender. The interesting factor here is the difference in the two yields. These issues are trading at material discounts to par value, so getting paid off at the face value would be an immediate upside of around 10% or more. The one that becomes callable sooner has a higher yield, which would make sense if the call was a major concern. If these shares were trading above call value, the disparity would make sense. Since they are trading at a material discount, I see the B series as being materially more attractive than the A series given the most recent pricing when I prepared this piece.
I may be a little biased because I am long shares of the common stock, but I see DX.PRA as being a fairly interesting play for the substantial yield. DX.PRB is offering a better discount to par value, but hoping for an immediate call is hoping for double-digit returns on preferred shares. I'd be very happy with returns in the upper single digits. My opinion, as a shareholder of the common, is that DX preferred shares are materially less risky than NYMT preferred shares.
The preferred shares on these mREITs look appealing when they trade at material discounts to call value. While the sector as a whole is trading at material discounts to book value, it also faces problems that are inherent to the business model. If the yield curve becomes steeper it means stronger earnings, but it also means some significant book value losses.
I see a couple shares that seem slightly too high relative to the other values in the table. The yield on NYMTP makes sense given their business holding IO strips (a useful asset, but risky) and CMBS first loss tranches (also very risky).
The difference in the relative values for DX seems a little too large. I would expect those to move a little closer together.
Disclosure: I am/we are long DX.
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.
Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.