3 High-Yield mREITs To Buy, 2 To Avoid

by: Todd Johnson

Investors are living in an unusual investing environment. Treasury bonds are at record low yields, as illustrated by the below chart. Retired investors and income-seeking investors need income to pay their bills. These same investors don't want a cookie-cutter approach to their income needs. They can have, however, 12% plus yields for part of their asset allocation. I recommend investors include mortgage real estate investment trusts (mREITs) and their 12% plus yields into their income portfolios. MFA Financial, Inc. (NYSE:MFA), for example, yields a 13.4% dividend.

Agency mREITs

Agency mREITs borrow funds via short term repurchase agreement rates. Agency mREITs use the funds to buy pass through mortgage backed securities. These securities are 100% implicitly guaranteed by the U.S Federal Government. The "pass through" securities are issued by agencies such as Fannie Mae, Freddie Mac, and Ginnie Mae. Agency mREITs profit on the gross yield margin between borrowing costs and high yielding pass through securities. The longer duration securities offer a higher yield than the borrowing costs. The mREIT then levers the gross interest spread by a 5.4x to 8x factor.

Non Agency mREITs

Non agency mREITs can possess both agency mortgage backed securities and non agency mortgage securities. Non agency securities are not backed by the U.S. Federal Government. Non agency mREITs are labeled as as hybrids because they do own securities with the U.S. Government guarantee and securities without a non agency guarantee. In this article, 5 Catalysts To Own PennyMac Mortgage, the staff have insight on what to look for in quality non agency mortgage backed securities. Stanford L. Kurland, CEO of PennyMac, was the CFO at Countrywide Financial. Mr. Kurland was the overseer of Countrywide expertise in establishing appropriate mortgage lending guidelines.


MFA Financial is a hybrid mREIT that invests in agency and non agency residential mortgage backed securities (RMBS). MFA's business model, in simplified terms, involves earning interest from its RMBS portfolio and financing its RMBS purchases using lower rate repurchase agreements. MFA thus earns the difference between the higher interest rate from its portfolio and the lower rate at which it borrows.

Business Strategy:

MFA invests primarily in hybrid and adjustable rate mortgages (ARMs). Hybrid mortgages typically have rates that are locked in for three to ten years, then adjust based on an increment over standard rates such as the one year constant maturity Treasury (CMT) or the London Interbank Offered Rate (LIBOR). ARMs typically adjust annual, and sometimes more frequently, for better or worse. MFA's strategy is to primarily invest in hybrid securities in preference to ARMS because ARMs reset more often. As a result, if rates rise, MFA's portfolio does not lose value to the extent longer-term fixed rate bonds do. MFA uses a leveraged business model where it relies on lower rate borrowings to fund RMBS purchases and generate profits after fund management expenses. MFA also actively seeks non agency mortgage backed securities selling at attractive discounts, well below face value, and so hopes to increase long-term shareholder returns.


For its fiscal year ended December 31, 2011, MFA reported interest income of $496.7 million, 26.9% higher than fiscal 2010, net income of $316.4 million which was 17.3 % higher annually, and earnings per share of 90 cents. It held $394 million in cash, $11.75 billion in total assets, $9.25 billion in total liabilities tied primarily to repurchase agreements and debt, and stockholders' equity of $2.5 billion.

MFA's book value per share, as of January 31st, was $7.10 per share. The book value increased due to non agency paper on MFA's balance sheet. Non agency securities increased in value during January 2012. It is well established that the economy is improving and the housing market is on an uptick.


MFA has regularly paid quarterly dividends since 1998. Quarterly dividends have fluctuated from 32 cents per share to a low of 5 cents. For its fourth quarter, MFA paid a regular dividend of 25 cents and a special dividend of 2 cents per share, with a rich dividend yield of 13.5%.


Over the years, MFA shares have traded in a fairly tight range around $7, with 52-week highs touching $8.64 and lows touching $6.23. As of March 1st, shares are trading at $7.25 against a book value of $7.10. The market capitalization is $2.65 billion (roughly a 3% premium to the $7.10 book value).

Peer Group:

Peers include American Capital Agency (NASDAQ:AGNC), Two Harbors Investment Corp (NYSE:TWO), AG Mortgage Investment Trust, I (NYSE:MITT), and NVESCO Mortgage Capital (NYSE:IVR).

American Capital Agency Corp.

In January 7, 2008, the American Capital Agency management, established American Capital Agency Corp. American Capital Agency is formally recognized as an agency mREIT. The mREIT guidelines requires American Capital Agency to distribute 90% of its earnings from agency mortgage-backed securities, where the guarantors of the mainly residential mortgages are Fannie Mae, Freddie Mac or Ginnie Mac. Aside from mortgage backed securities, American Capital Agency at times also invests in agency debentures - but within the limits of Fannie Mae, Freddie Mac or the Federal Home Loan Bank, as required by the mREIT classification. And in return for limiting its real estate investments to Fannie Mae, Freddie Mac or Ginnie Mac, AGNC corporate tax payments are held to a minimum.

The goal of American Capital Agency is to preserve its stockholders' book value per share while earning income from its investments in agency mortgage backed securities and agency debentures that are backed by the government-sponsored entities. American Capital Agency has declared a $1.25 per share quarterly dividend, or an annualized $5.00 per share dividend. Compared to last year, this quarterly dividend is a decrease from the last quarterly dividend at $1.40 per share. The dividends will be payable on April 27, 2012, to stockholders holding the stock on ex-dividend date of March 5, 2012.


I believe investors should buy American Capital Agency. The company has outperformed the entire mREIT peer group over the past 4-5 years. Management is top notch and is an open book to shareholders. There is nothing not to like, in which I can discover, to not own the best of breed mREIT name.

Two Harbors Investment Corp

Two Harbors Investment Corp is a corporation based in Maryland, founded in May 21, 2009. A relatively new corporation, Two Harbors Investment is a hybrid mREIT. Two Harbors Investment generates earnings from the acquisitions, holdings and management of agency mortgage backed securities, residential mortgage loans, real properties and any other financial asset that is well within the limitations of being a hybrid mREIT.

On October 28, 2009, TWO merged with Capitol Acquisition Corp., making Capitol a subsidiary of Two Harbors Investment. Two Harbors Investment targets acquisitions in residential mortgage backed securities often guaranteed by entities such as Fannie Mae, Freddie Mac or Ginnie Mac, though sometimes the guarantors may not be such entities. Other financial assets outside of residential loans and real properties make up around 5% to 10% of Two Harbors Investment's investments. As a mREIT, Two Harbors Investment is also required to share 90% of its net income to its stockholders in return for single taxation for the corporate entity as prescribed by federal law.

The core earnings of Two Harbors Investment amounted to $55.6 million for the quarterly period ending December 31s, 2011. This resulted in 40 cents per weighted diluted share. Two Harbors Investment also successfully launched 2 secondaries this quarter. Clearly the housing recovery has increased the value of non agency securities. Jobs create stability for housing prices. Two Harbors is benefiting by their astute awareness of the U.S. economy backdrop. Shares are trading at a 12% premium to book value per share.


I believe investors should avoid purchasing Two Harbors. A hybrid mREIT, trading at 12% premium to net asset value, is not for the feint at heart.

AG Mortgage Investment Trust, I

AG Mortgage Investment Trust, I is a corporation based in Maryland, operating as a real estate investment trust (REIT). Through the acquisition and holding of agency residential mortgage backed securities guaranteed by government entities like Fannie Mae, Ginnie Mae or Freddie Mac, the exposure to risk is minimized, but AG Mortgage Investment Trust aims further than this. At some future point in time, AG Mortgage Investment Trust also aims to increase its holdings in non agency residential mortgage backed securities, and include fixed and floating rate securities, in addition to investment grades ranging from AAA through BBB, and BB and below. This will revoke AG Mortgage Investment Trust's mREIT status in the future, but at present, 90% of its earnings are dutifully distributed to its stockholders, with all the advantages of being classified as a mREIT under federal law.

AG Mortgage Investment Trust reported today a book value per share of $20.52.

AG Mortgage Investment Trust is also externally managed by AG REIT Management, LLC, and as such, benefits from the additional relationships, resources and other information from AG REIT Management, LLC. Today, March 1, 2012, the AG Mortgage Investment Trust, presented their 4th Quarter 2011 earnings call. In January 24, 2012, AG Mortgage Investment Trust closed the sale of 5 million shares of common stock, and plans the settlement of the sale of 750,000 more shares of common stock in exercise of its underwriters' option.


I believe AG Mortgage should be purchased. They proved today, March 1st, that they are trading below book value per share.

INVESCO Mortgage Capital

INVESCO Mortgage Capital is a Maryland real estate investment trust (REIT), founded in July, 2009, and run by INVESCO Advisors Inc. in a managerial capacity. Through INVESCO Advisors, INVESCO Mortgage Capital has managed to acquire commitments for repurchase agreements, lengthening the reach of its capital and resources. These repurchase agreements were then used to pay and replace the US government's Term Asset Backed Securities Loan Facility financing with INVESCO Mortgage Capital.

The company's annual meeting, announced on March 1st, will be held on March 3rd.

Qualifying as a mREIT, INVESCO Mortgage Capital shares 90% of its net income with its stockholders, in return for more favorable federal laws regarding mREITs. The target assets of IVR are residential mortgage backed securities guaranteed by entities such as Fannie Mae, Ginnie Mae or Freddie Mac. INVESCO Mortgage Capital also invests in non agency residential mortgage backed securities, commercial backed securities and mortgage loans from residential and commercial sources.

On February 22, 2012, INVESCO Mortgage Capital released its financial report for the period ending December 31, 2011. The results of the report was at 66 cents per diluted share for the fourth quarter of 2011, or a net income of $76.5 million. The reported book value of INVESCO Mortgage Capital was at $16.41 by the end of December, 2011. The reason cited for the improved book value of INVESCO Mortgage Capital was improved economic conditions in the country.


I believe if investors want to own hybrid mREITs, then engage in a pair trade. Short Two Harbors and go long I NVESCO Mortgage Capital. INVESCO Mortgage Capital has core investments in non agency mortgage backed securities and is trading at a lower premium to net asset value compared to Two Harbors' valuation. On a stand alone basis, I do not recommend investing in INVESCO Mortgage Capital due to their historical lack of acceptable derivative risk controls and below average total annualized rate of returns.


MFA shares appear to offer some downside protection based on price history. Its dividend yield is very attractive at current levels and its shares seem reasonably priced too. All in all, MFA appears to be a strong company with capable management with a proven record of delivering dividends and stock price stability while also growing earnings.


I strongly recommend investors consider agency mortgage real estate investment trusts as part of their asset allocation. The Federal Reserve's decision to keep interest rates low is in the benefit of agency mREIT holders.

If an investor believes the economy is really improving, then non agency mREITs offer great value as non agency mortgage backed securities will only increase in value. The individual investor will need to decide if the economy is improving.

My Personal Opinion

My personal opinion is the economy is fragile, unemployment is higher than reported by the government, and the Federal Reserve's printing of money is not good for the long term health of the economy.

Disclosure: I am long MFA, AGNC, MITT.