Thanks to the authors that contributed to this article. Mortgage REITs are a tough call these days, and so I wanted to mention that there were a number of contributors who said they wanted to contribute, but that they felt like they don't feel sure enough for a long term suggestion right now. That says something, and I thought it was important to mention it. As usual with this series, this been fun and educational. Mortgage REITs are controversial. Let's talk about it! What do you think?
This article is an explanation of what Mortgage Real Estate Investment Trusts (mREITs) are, and an interview of 5 Seeking Alpha contributors (authors) asking them the following questions which include mREIT picks:
Question one - If you had to pick one high yield Mortgage REIT that you felt comfortable with putting in your own long term retirement portfolio and leaving it there for the next five years (couldn't sell it), which one would it be?
Question two - If you had to pick a more speculative high yield Mortgage REIT that you felt like has the potential to be a good one over next five years, which one would it be?
Primer on Mortgage REITs
1) What are Mortgage Real Estate Investment Trusts
Mortgage REITs are a subset of all Real Estate Investment Trusts (REITs). mREITs are companies that invest more specifically in a range of mortgage-related assets. Some of the companies just hold mortgages that are insured by federal government agencies. Others hold some or all non-agency mortgages too. They sometimes invest in Mortgage Servicing Rights (MSR) or other mortgage related investments too. You have to read the information on each mREIT individually to know what you are investing in. They can be very complex.
2) Are the dividends steady?
One often unrealized thing about mREITs is that they are variable rate dividend payers by definition. The dividends can and do vary. mREITs are legally required to pay at least 90% of their taxable income to investors, so when they make more they pay you more, and when they make less they pay you less. You often see the market price of mREITs swing wildly when the dividends are bumped higher or lower. Some smart mREITs will not try to pay out more than they earn. Rather than borrowing or issuing more shares to pay out a dividend bigger than they earn (more than 100% of their taxable income), they lower it. However, the market often punishes them for this responsible behavior. It can be perplexing. Sometimes it is a buying opportunity. Sometimes, it is a sign of more problems to come. mREITs are not simple. They have a high complexity factor.
3) How rate sensitive are Mortgage Real Estate Investment Trusts, and do they differ in that respect from other types of REITs?
All mREITs are rate sensitive, but they are all different in that regard. Some borrow funds long term. Some borrow short term. Some borrow at fixed rates. Some borrow at adjustable rates. Many are hedged or use complicated derivatives. These factors and others affect their sensitivity to interest rates. There is a simple way to digest all of these factors. The place to look is in their FORM 10-Q which they are required to issue, and you can find on the company's website. They tell you their interest rate sensitivity information very specifically in an easy to read and understand table (usually one of the last pages in the report). The table will show, for example, a very specific estimate that the projected effect of a +100, or +50, or 0, or -50 etc. basis point interest rate change would have on the company's Net Asset Value, Portfolio Market Value, and Net Interest Income. Depending on your view of which way interest rates are headed, this could be important information for you.
In the past, mREITs have done poorly in time of rising interest rates. For example, the Fed Funds rate rose steadily from the beginning of 2004 to the beginning of 2006. Some of the REITs that survived that time period and the great recession are still around. The effect on them at that time was devastating. They got nailed big time according to the data on Yahoo. Here are some examples:
Annaly Capital Management, Inc. (NYSE:NLY) was around $19.50 at the beginning of 2004, and closer to $12.50 by the beginning of 2006
Anworth Mortgage (NYSE:ANH) was around $14 at the beginning of 2004, and closer to $8 by the beginning of 2006
Capstead Mortgage Corp. (NYSE:CMO) was around $17.40 at the beginning of 2004, and closer to $7.50 by the beginning of 2006
MFA Financial, Inc. (NYSE:MFA) was around $10.00 at the beginning of 2004, and closer to $6.50 by the beginning of 2006
Now let's compare that to the MSCI US REIT (RMZ) Index during the same time period of rising interest rates (beginning of 2004 till the end of 2006). This index is a composite index of REITs of which mREITs are a small component:
The MSCI US REIT Index (RMZ) was around 610 at the beginning of 2004, and around 899 by the beginning of 2006. This was exactly the opposite of what happened to mREITs.
Counter to what most people seem to think, and to how the market has reacted recently to the prospect of higher interest rates, REITs did very well indeed during the time of rapidly rising rates between 2004 and the end of 2006. However… while the majority of REITs went up during the period of steadily increasing interest rates from 2004 through 2006, mREITs plummeted.
Times have changed, but it does throw up a giant red flag for some mREITs if interest rates rise. Now mREIT management knows what happened then, and should be better prepared with hedges and other types of investments if it happens again. Some, such as New Residential Investment Corp. (NYSE:NRZ) even claim they will do better when interests rates rise because of the types of mortgage assets they hold and their hedging. mREITs require a lot of due diligence.
One take I have is that on the one hand they make me nervous because they are complex and evolving, but on the other hand… some have been survivors. As mentioned above, some survived not only the interest rate rise of 2004 through 2006, but also the 2008 recession. Given that history, and the high steady dividend rate of the preferred issues, it pushes me personally to look more in that direction. I would suggest doing due diligence and considering them also.
My Focus and Thoughts
My investment focus is on growth and income with higher yielding dividend stocks. I recently retired, and I love dividends, but I love dividends even more if they grow. I lost my business and pretty much everything I had built up in a fire about 10 years ago. I was underinsured, and to add insult to injury, the recession came. I was determined to find a way to build up enough money to retire, but the window was short. I went way out on a high risk limb and short term traded in and out of very high dividend stocks (dividends over 10% which provided a lot of volatility for trading). I started with a relatively small amount in an IRA, and somehow it worked. I was able to build up and squirrel away enough to retire recently. That required a lot of attention to detail and sweat, and I don't want that risk anymore. So, I decided to interview some prominent Seeking Alpha authors by asking them some relevant questions on various topics that would help income investors and others to consider about some alternatives.
This is the fourth in the series.
Here are links to the other three:
I promised everyone that I would make it clear in the article that their picks are speculative and are not recommendations, as the length of the responses are not long enough to explain detailed recommendations. These picks are nutshell summaries, and should serve as food for thought. A lot of due diligence should be done on any of them. Also note that in this article, the term dividends and distributions will be used interchangeably (think of both as income). We all know there is a difference, but for the purpose of this article, we are going to think of both of them as income you might receive. So, let's not over complicate things with semantics.
What do the Authors Think?
The authors and their responses are in reverse alphabetical order by first name.
1) Scott Kennedy - Scott is a Certified Public Accountant (CPQ) and a Certified Financial Planner (CFP) (not private practice). He is currently employed with a global accounting firm in the Northeast area (partner). He has masters degrees in accounting and legal studies, and experience with audit, tax, and consulting entities in the following sectors: closed-end funds, energy, financials, healthcare, homebuilders, pharmaceuticals, private equity, REITs, and telecoms.
"Regarding the mREITs, many stocks were trading at material discounts to Book Value (BV) several months ago. At that time, I was more bullish on the entire sector. More recently, the sector has, as a whole, traded much closer to BV. As such, I don't see this sector as attractive as it was only a few months ago.
With that being said, for a long-term play (question 1), I've continued to own American Capital Agency Corp. (NASDAQ:AGNC) (Dividend Rate around noon on May 11th 2016 was 12.56%). I believe AGNC's management team has, over the long-term, outperformed most of its sector peers. I believe a management team is a key component in this sector due to the "ever-changing" variables at play which are directly impacted by changes in the yield curve. Dependent upon the yield curve, a management team needs to "evolve"/change a company's MBS and derivatives portfolio. So, even though I currently have a HOLD rating on AGNC, I have held this investment for multiple years and have received the double digit annual dividend yield. If AGNC is trading at a material discount at the time of the monthly dividend distribution (which has been the case for the past two+ years), I have reinvested all dividends. I plan to hold this stock over the next several years, as long as the stock doesn't begin to trade at a premium to BV. A recent AGNC quarterly assessment article I wrote provides more detail on this company's recent business operations.
For more of a "speculative trade" (question 2), I would take a look at Orchid Island Capital Inc. (NYSE:ORC) (Dividend Rate around noon on May 11th 2016 was 16.34%). This is a smaller capitalized stock which typically tends to have more "volatile" movements in its stock price (larger price swings that your typical mREIT). During the past year, I've "traded" this stock three separate times for short-term gains of 26%, 16%, and more recently 18% (all trades were disclosed to readers in "real time" (that day) via the "StockTalks" feature of Seeking Alpha).
After the company reported what some investors would interpret as a "negative" quarter due to the (5%) decrease in BV, ORC sold off nearly (10%) the very next day. At the time, I believed that was excessive devaluation because the company continued to report strong dividend metrics. As such, on 4/28/2016, I re-entered ORC at a weighted average purchase price of $9.325 per share. Since the company currently generates an annual dividend yield of 16.7% (18% at my purchase price), I believe this is an attractive, income-producing equity investment.
I like ORC due to the fact this mREIT will outperform most sector peers when interest rates gradually increase (which has a high probability of occurring at some point in the future). This type of scenario would occur if the Federal Open Market Committee (FOMC) gradually increases the Federal (Fed) Funds Rate. This is due to the fact the company owns higher-coupon agency MBS via the company's "pass-through" portfolio and also has a securitization portfolio of agency interest-only (IO) and inverse interest-only (IIO) securities. Simply put, ORC is naturally "set-up" for a gradual rise in interest rates and will outperform most sector peers under this type of scenario. My recent ORC dividend sustainability article explains why the company's dividend should remain at $0.14 per share in the coming months"
Scott owns AGNC and ORC
2) Rida Morwa - Rida Morwa is a former Investment and Commercial Banker with over 30 years experience in the field. He is the author of "High Dividend Opportunities", a premium subscription service at Seeking Alpha, dedicated to bring investors the most profitable and newest high dividend ideas.
Rida had an answer that was very similar to what I heard from a number of contributors about mREITs in general.
"I am not too fond of MREITs in the current interest rate environment. By nature, MREITs tend to lend long and borrow short, so any increase in US interest rates can have a negative effect on their profitability. If you add to this the fact that most Mortgage REITs are 4 times leveraged, any slight rate increase by the fed will have a magnifying effect and can possibly be detrimental. It is my opinion that Mortgage REITs are best held when interest rates are trending lower. In the current environment, MREITs are vulnerable investments.
For high-yield investors, the best alternatives to MREITs are Business Development Companies (BDCs). Studies have shown that most BDCs, and in particular larger ones, do not exhibit statistically significant sensitivity to small interest rate hikes, which is in contrast to MREITs. This is due to the fact that most BDCs have their assets invested in much shorter maturities than those of MREITs. As such, they possess a more favorable asset-liability structure.
Furthermore, the majority of BDC investments consist of floating rate loans which are primarily funded with fixed rate term debt; this makes BDC loan portfolios better positioned for rising interest rates when compared with the majority of fixed income products. It is estimated that about 77% of BDC debt investments currently bear floating rates. My best two picks in this sector are Prospect Capital (NASDAQ:PSEC) (Dividend Rate around noon on May 11th 2016 was 13.46%) and the Exchange Traded Note UBS ETRACS Wells Fargo Business Development Company ETN (Dividend Rate around noon on May 11th 2016 was 8.95%).
I am fond of BDCS in particular. This ETN tracks the major listed BDC companies and holds about 44 BDC companies in its portfolio. BDCS currently yields 8.9%. My experience has taught me that it is better to long the BDC sector through Traded Funds rather than individual companies. This strategy is not only safer, but likely to achieve better results over the long run."
Rida owns BDCL (The leveraged x2 version of BDCS with double its yield) and PSEC
3) Lance Brofman - Lance has an extensive background. He has a Ph.D. in economics and an MBA in finance from the Globe Institute of Technology. He is a Professor - Economics and Finance, Chair of Business Department Colorado Technical University Adjunct Professor - courses: Applied Managerial Finance (Graduate Level), Microeconomics, International Finance European School Of Economics (New York Campus) Adjunct Professor - Economics (Graduate Level) Courses taught: Microeconomics Metropolitan College of New York Adjunct Professor - Economics, Banking and Finance Courses taught: History of Economic Thought, Macroeconomics, Money and Financial Institutions World Gold Council Consultant Economist New York, NY, and much more. Check out his bio some time. Needless to say, Lance is a distinguished contributor.
"I own UBS ETRACS Monthly Pay 2X Leveraged Mortgage REIT ETN (NYSEARCA:MORL) (Distribution Rate around noon on May 11th 2016 was 20.89%) which is a ETN comprised of high yield Mortgage REITs. Click here to read his latest article on MORL.
If that does not count my pick for a single mREIT would be CYS Investments Inc. (NYSE:CYS) which I also own.
A more speculative high yield Mortgage REIT that you felt like has the potential to be a good one over next five years, is Orchid Island Capital (Dividend Rate around noon on May 11th 2016 was 16.34%) which I also own."
Lance owns MORL, CYS, and ORC.
4) Fredrik Arnold - In 2012 Fredrik retired from doing quality service analysis for John Hancock Long Term Care Insurance in Boston. He has a fascination with capital preservation, fixed fractional trading, and trading systems which keep him blogging for Seeking Alpha. Most of his articles focus on dividend yields and analyst mean 1 yr targets as stock trading indicators. He considers these essential tools for catching the most valuable "dividend dogs". He has had a number of popular articles here on Seeking Alpha. Fred says to check out his The Dividend Dog Catcher premium site. Here are some of his follower favorite articles, Followers Favor Monthly Pay Dividend Dogs in April Survey, Johnson & Johnson Ties AT&T as Follower Favorite Dividend Dogs For March, and Memorial Production Partners Leads Follower Favorite Dividend Dogs.
"There's only one mREIT I'd be comfortable putting in a 5 year or longer retirement portfolio: Annaly Capital Management, Inc. (Dividend Rate around noon on May 11th 2016 was 10.89%). Three reasons:  NLY is the only large cap mREIT.  It has shown upside momentum for the past year, year to date, and the past week.  It is one of only five mREITs mentioned as a favorite dividend stock by my followers.
In September I surveyed 4,000 or so identified as Fredrik Arnold followers. I asked them to name their favorite dividend stock. I repeated the survey to increasing numbers of followers in December, March, and April. I am repeating the survey now to 6K followers.
Concerning the more speculative pick, again the followers speak. The most frequently mentioned mREIT in all my follower responses is Orchid Island Capital, Inc. (Dividend Rate around noon on May 11th 2016 was 16.34%). It has the additional advantage of paying distributions monthly. As for momentum, ORC is down in price 30% since inception in 2013; down 28% over the past year, up in price 3.2% year to date, an up 8% over the last 5 days.
These recommendations display investor democracy in action. I own neither of these stocks.
Fred does not own NLY or ORC.
5) Dividend Don - I am an antique dealer and an indie pop rock musician who retired from corporate America. I have worked in Market Research at Procter & Gamble (NYSE:PG), as an independent business owner, and also as a Healthcare professional. My focus as stated in the beginning of this article is on dividend stocks, particularly those with growth potential, and those that are overlooked by the market.
"My first pick is New York Mortgage Trust, Inc. Preferred O (NASDAQ:NYMTO) (Dividend Rate around noon on May 11th 2016 was 9.08%). As I mentioned above, there is a lot of uncertainty in my mind about mREITs in general right now. NYMT invests in Agency and non-Agency mortgage-backed securities, residential adjustable rate loans, commercial loans, and other financial assets. They have been around since the middle of 2004 and is one of the survivors. They had a really nice run, increasing or holding dividends steady from 2007 till 2015. They ran into some problems in mid 2015 and finally had to cut the dividend by 3¢. I think they have good management, but hit a rough patch. I think they are going to be around for a long time. NYMTO preferred issue (NYMTO) appeals to me. This is the Series C 7.875% cumulative preferred stock that is currently selling at around $21.75 (this is a big discount from the $25 call price which they can redeem at any time on or after 4/22/20). At this price, the yield is north of 9%. Contributor Brad Thomas wrote what I consider a great article recently on NYMTO which you can read by Clicking Here.
My second pick is Apollo Commercial Real Estate Finance (NYSE:ARI) (Dividend Rate around noon on May 11th 2016 was 11.52%). You might say, wait, that's not an mREIT. But it is in part. They merged with Apollo Residential Mortgage (NYSE:AMTG) in February. I like this one a lot. They invest in a wide range of real estate debt investments, and go where the best deals are. They don't limit themselves. They carry a lot of commercial first mortgage loans and securities, subordinate financings, and other investments which included AMTG. They are very diversified as to property types and geographies. They have consistently increasing earnings. They have been around since 2010 and kept their dividend which is currently nearly 11 1/2% stable or growing the whole time. They also emphasize variable rate investments which are much less vulnerable to problems created from interest rate rises.
One other that I do not own, but am considering, but haven't made the leap yet is New Residential Investment Corp. (Dividend Rate around noon on May 11th 2016 was 13.97%) which has done well and claims will do well in a rising interest rate environment. There are a number of Seeking Alpha write ups since January on this stock, so if you are considering it, I would suggest reading them all."
Don owns NYMTO and ARI.
In conclusion: Perhaps this article will inspire some readers to add some other ideas to the conversation. What do you think?
Disclosure: I am/we are long NYMTO, ARI.
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.
Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.