An 11.48% Yield That Is Stronger Than It Looks

Summary

• Recent analysis suggested ARMOUR Residential REIT's dividend was in trouble, but I am disputing that thesis.
• One challenge in evaluating the REIT is the different meanings of "leverage".
• When ARMOUR Residential REIT provides its portfolio updates, the leverage figures exclude its TBA positions.

Subscribers received an advance look at this article.

A recent article on ARMOUR Residential REIT (NYSE:NYSE:ARR) brought out some concern among shareholders and potential investors in the mREIT. The article suggests ARR's dividend is in trouble. While I'm not saying the company's dividend is rock-solid, I do believe an informed investor could come away from the piece thinking that a dividend cut was a near certainty. While there are quite a few mortgage REITs that are clearly not covering their current dividend, ARR does not fall into that group.

To be clear, I respect the author of the other piece, and it is to his credit that his work was convincing enough to make intelligent investors question their beliefs.

Source

This article uses slides from ARR's monthly portfolio presentations. They are the primary tool for preparing this analysis.

Method

To assess the strategy ARR is using and the most likely future results, it is critical to define the term "leverage". Investors and analysts can easily use the term without specifying exactly what they mean, so I want to hammer it out to avoid any confusion.

Leverage

There are two kinds of leverage for a mortgage REIT. There is GAAP leverage, which is more easily seen, and there is economic leverage. If you can divide assets by equity, you can get a feel for GAAP leverage very quickly. Economic leverage, on the other hand, looks at the amount of leverage implied through the use of derivatives. Specifically, I'm referencing TBAs. That stands for "To Be Announced". These securities are an agreement to buy at a pool of securities at a future date.

One of the funny things about accounting is that the mREIT has an economic ownership of the assets, but the assets don't really belong to them yet. The last word is critical. The TBA securities cause the mREIT to gain or lose book value based on the change in the fair value of the bonds that are scheduled to be delivered.

Because a mortgage REIT doesn't own the security (it owns an interest in the price change), it does not receive interest income or need to use repo agreements to fund the transaction. The only entry an investor might see on the balance sheet is a small "fair value" assigned to the position based on whether it is in a gain or a loss. That is the fair value of the expected change in the price of the security, so that value could easily be a mere .1% of the size of the contract.

Look at ARR's Leverage

This first chart is from April 2016:

The green box indicates that GAAP leverage was 9.0. The yellow box indicates the estimated book value range.

The next chart comes from August 2016:

The GAAP leverage, again in the green box, has been declining over time. Meanwhile, the yellow box indicating book value has been climbing materially each month.

An increase in book value means more equity, so if a mortgage REIT continued to hold the same asset positions but saw its equity value increase, it would decrease the leverage, because "equity" would be a larger number in the "Assets/Equity = Leverage" equation. However, the gain in equity wouldn't be large enough to cause this drop in leverage. Therefore, we need to talk more about the use of TBA securities.

Remember that TBA securities are not included in calculating leverage under GAAP. When ARR provides its "leverage" figure, the REIT specifies (as shown by the red arrow) that it is using leverage values that do not assign any value to the use of TBA securities.

Drop Income

Because a mortgage REIT agreeing to buy those securities is taking on risk that is very similar to actually owning the securities, it requires payment. Since there is no interest income yet, the TBA securities are designed to have a slightly lower price than the securities would have if they were trading on the open market. If nothing changes, the mortgage REIT would expect to realize a slight gain on the position if it ended the position or rolled it over just prior to maturity. That slight gain is designed to offset the mortgage REIT missing out on "interest income". The term for that built-in gain is "drop income".

Some Mortgage REITs Use This Frequently

Some mortgage REITs use this much more often than others, and some change their use of it over time based on the appeal of the TBA securities. For instance, American Capital Agency Corp. (NASDAQ:AGNC) was brilliant in its use of TBA securities. The company was assessing whether it could expect to earn more interest income from owning MBS or more drop income from using TBA positions instead.

Comprehensive Income

There is some very intelligent debate over the use of drop income as a way to strengthen book value or a way to produce more income for distributing in dividends. For now, I'll just point to the idea that "Comprehensive Income" should be a critical factor over the long term. The comprehensive income is the change in book value after adding the amount of the dividend. Unfortunately, comprehensive income can spike quite a bit on a quarterly basis, so it is unwise to use the level of comprehensive income for a single quarter to sum up an entire mortgage REIT. However, measuring it over the span of a few years is a very appropriate way to measure a mortgage REIT.

Conclusion

Did ARMOUR Residential REIT reduce leverage? The company reduced it dramatically, if we are discussing the GAAP leverage. If the discussion focuses on the total economic leverage, which includes TBA securities, then the decline in leverage would've been much smaller.

The leverage ARR is providing is simply dividing repurchase agreements by total equity. At the end of August, the value was $7.77 billion. Dividing that by about $1.2 billion (rounded) in total equity (including preferred shares) gives investors a leverage of 6.5. If you incorporate $2.5 billion in TBA securities, the leverage would move up to about 8.6.

Want to Know More About Mortgage REITs and Preferred Shares?

Since the Mortgage REIT Forum is a new exclusive research platform, the first 100 subscribers will be able to lock in their subscription rates at only $240/year. My investment ideas emphasize finding undervalued mortgage REITs, triple net lease REITs, and preferred shares. With the market at relatively high levels, there is also significant work on finding which securities are overvalued to protect investors from losing a chunk of their portfolio. This article specifically did not mention the valuation of the mREIT because I cover that topic at least on a weekly basis for subscribers.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in EITHER MREIT OR THE PREFERRED SHARES over the next 72 hours. 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.