Agency Mortgage REITs: A Broken Business Model

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Includes: MORL, MORT, REM
by: REITBear2016
Summary

Yields are too low.

Spreads are too tight.

Management teams are crooked.

Taxable income and earnings on mortgage REITs today do not correspond with economic returns on underlying assets.

I believe that REIT dividend yields are 8­-10% higher than forward economic returns assuming an extremely benign economic and interest rate scenario.

1. Most businesses go to great lengths to reduce taxable income. This is not the case with mortgage REITs. By virtue of their tax exempt status from passing through taxable income to the shareholder, REITs avoid paying corporate level taxes. REITs should not be evaluated on the basis of dividend yield, but this is all too commonly the case in the short ­term.

REITs were launched by fixed income asset managers seeking permanent capital and marketed to retail. REIT managers have oversimplified and fundamentally misrepresented their business model to investors.

REIT managers manufacture taxable income by realizing gains, but not realizing losses. Also, they use forward starting swaps and futures to hedge MBS. This means the income from the asset is recognized as a gain, but there is no interest expense showing up as a hedge. As a result, NAV will be lower in the next reporting period, but the dividend yield remains elevated.

Below is a back of the envelope calculation for the upper bound​ of economic return over the life of the assets for an mREIT with zero duration gap and six turns of leverage on a typical portfolio

comprised of 15yr and 30yr MBS:

ROE = Unlevered yield on asset + (Unlevered Yield on Asset­-Repo and hedging costs)*D/E -­ Mgmt Fee­s - other Expenses

ROE = 2% + (80bp­-20bp)*6 -­ 1% - ­ 0.60%

ROE = 4%

Mortgage REITs pay out nearly 3x this amount currently. Given that REITs are paying out a "dividend" significantly in excess of what they are earning economically, they are likely to lose NAV every quarter. REITs' NAV will only increase in quarters when Agency MBS spreads tighten substantially. As an aside, Q3 2016 was possibly the most favorable environment for Agency MBS spreads since QE3 was announced in 2012. Q4 2016 is not shaping up as favorably.

If interest rates move in either direction, mREITs will be subject to convexity losses, which will lower the ROE number calculated above. Using inputs from standard interest rate volatility models to calculate the expected return on Agency MBS, the ROE in a base case economic scenario is much closer to 1%.

To underscore this point, REITs advertise low double digit yields, but present investors with a 1% expected return, pre­tax. 1% is a staggeringly low expected return, even in the current low yield environment. For reference, 3-month FDIC insured bank CDs can be found that pay 1.25%. So there are alternatives out there that provide safe and secure income without taking unnecessary risk.

2. The structure of REITs is inherently shareholder unfriendly.

Most mREITs are chartered in Maryland because of protections management teams receive via the Maryland Unsolicited Takeover Act. The act permits classified boards; a two­-thirds vote of outstanding shares to remove a director; a requirement that the number of directors be fixed only by vote of the board of directors; and a requirement that a vacancy on the board of directors be filled only by the affirmative vote of a majority of the remaining directors.

While activists have achieved some traction, most of the activity only occurred at distressed valuations and resulted in a smaller REIT being sold to a larger REIT that rolled up to the same management company (i.e. Javelin sold to Armour and Apollo Residential sold to Apollo Commercial.

REIT managers exploit their power over investors via more shenanigans.

REIT managers calculate the fees charged to investors using up to three years of prior NAV and add back unrealized losses. Since dividends are too high relative to economic return, using a prior NAV means investors are almost always paying too high a management fee relative to the headline fee disclosure in presentations. The add-back of unrealized losses creates a further divide between management and shareholders as management can be highly conflicted over whether or not to sell a story bond position when the catalyst has failed to play out the way they had hoped.

REIT managers have also issued preferred stock at 7.5-­8.5% yields. In fact, pre­-crisis, when risk free rates were in the neighborhood of 4­-5% in 2005-7, REIT preferreds were issued at these same 7.5-­8.5% yields. So despite global fixed income yields approaching intergenerational lows, REIT preferred stock yields haven't budged. It's then curious why REIT managers would decide to issue preferreds until one recognizes that REIT managers are paid a management fee of 1­-1.50% on all preferred issued. Management has found another avenue of enrichment at the expense of the shareholder.

3. Valuations are very high, especially on a layered basis.

Since Q1 2016, price to book discounts have receded and shares have rallied 15-35% off their February lows. Several mortgage REITs now trade between 90% and 100% of book value. Current valuations offer little to no margin of safety if interest rates rise or mortgage spreads widen.

Mortgage spreads relative to US Treasuries are currently in the 97th percentile of richness over a 20yr history. US Treasuries and global fixed income yields are finally rising from intergenerational lows. Rates and spreads seemingly have much more room to go higher rather than lower.

All mREITs employ leverage, which creates path dependency. We don't need a black swan event for mREITs to suffer a 50% loss in share price. If mortgage spreads widen to historically average levels after the Federal Reserve tapers reinvestment of paydowns (QE3), losses may exceed 50% of today's NAVs before taking into account any impact from Price to Book devaluation in shares.

Mortgage REITs rely on repurchase financing to fund their investments. As counterparties pullback from this market due to supplementary leverage ratio constraints, repo becomes more expensive (better case) and possibly unavailable (worse case).

Regardless, NIM and NAV can be further eroded.

If nothing else, shorting mortgage REITs provides portfolio insurance at a very cheap level.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.