Quick And Dirty mREIT Discounts

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Includes: AGNC, AI, ANH, ARR, CHMI, CIM, CMO, DX, EARN, IVR, MFA, MITT, MORL, MORT, NLY, NYMT, ORC, REM, TWO, WMC
by: Colorado Wealth Management Fund
Summary

We were severely bearish on the residential mortgage REIT sector for much of the last 2 years. The residential mortgage REITs delivered dreadful total return performance.

Plunging values throughout the residential mortgage REIT sector are leading us to several upgrades.

We're sharing ratings on over half of the residential mortgage REITs and providing price-to-estimated-tangible book value. Our values incorporate expected changes in book value.

This research report was produced by The REIT Forum with assistance from Big Dog Investments.

The residential mortgage REITs plunged over the last few weeks. After significant price swings, we have an excellent opportunity to reevaluate the relative attractiveness throughout the sector.

We were severely bearish on this sector for most of the last 2 years and took a great deal of criticism for our stance. The latest movements have vindicated our stance as prices plunged. Now investors have much better opportunities to put capital to work in the common shares compared to almost any point in the prior 24 months. Many of these mortgage REITs are trading near 52-week lows.

The recent rise in Treasury yields will have created damage to book value for many of these mortgage REITs. The impact is significant and investors should consider the damage. However, the price movements in many cases were much larger than the movement in book value.

The mREITs

I put most of the residential mREITs, one corporation, two ETFs, and one ETN into the table:

(AGNC)

American Capital Agency Corp.

(AI)

Arlington Asset Investment Corporation

Not a REIT

(ANH)

Anworth Mortgage Asset Corporation

(ARR)

ARMOUR Residential REIT

(CHMI)

Cherry Hill Mortgage Investment

(CIM)

Chimera Investment Corporation

(CMO)

Capstead Mortgage Corporation

(DX)

Dynex Capital

(EARN)

Ellington Residential Mortgage REIT

(IVR)

Invesco Mortgage Capital

(MFA)

MFA Financial

(MITT)

AG Mortgage Investment Trust, Inc.

(NLY)

Annaly Capital Management

(NYMT)

New York Mortgage Trust

(ORC)

Orchid Island Capital

(TWO)

Two Harbors Investment Corp.

(WMC)

Western Asset Mortgage Capital Corp.

(REM)

iShares Mortgage Real Estate Capped ETF

(MORT)

VanEck Vectors Mortgage REIT Income ETF

(MORL)

UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN

The goal here is to have a fairly large sample size so we can identify trends and similarities throughout the sector. The mREIT sector only contains about 25 total organizations, but the investing and hedging strategies have very material differences.

Price-to-Book Value

We tend to use tangible book value. That's like GAAP book value, but if we spot significant allowances related to tax assets or goodwill, we eliminate those from equity. Consequently, the book value we are using may be different from what you're seeing elsewhere.

We also correctly handled preferred equity. If you're seeing a value that is dramatically different than what we are presenting, the most common cause is a failure of the other tool to properly handle preferred equity. We are regularly challenged on these numbers, but we are consistently right.

We also adjusted for the accrual of net interest income through the quarter and deducted the amount for dividends paid. In some cases, we may also have slight adjustments to reflect the estimated change in BV due to movements in interest rates or credit spreads. This is one such case. Some public articles simply use the discount to trailing book value. We could do that, but it would require creating another set of charts. We would rather just use a limited version of the chart we produce for subscribers. Consequently, you'll have our estimates for the change in book value that has occurred between 6/30/2018 and 10/11/2018.

We believe having these changes incorporated leads to much better analysis because it effectively incorporates the expected third-quarter results.

A Slight Lag Time

To make it simpler to keep these articles coming out for the public, we may use prices from the prior week.

For today's piece, we're using prices and projected BV as of 10/11/2018 during the trading day. The only change to our BV estimates since then is that ARR went ex-dividend one additional time resulting in a reduction to BV of about 1%. Shares dipped on Friday and bounced back so far on Monday, so our ratings should still be highly relevant. Regardless, investors should verify the price in the trade screen with the price in the chart for evaluating the price-to-book.

Residential Mortgage REITs

Below is our chart for price-to-tangible-book on the residential mortgage REITs:

In the chart above, the dividend yields for NLY and TWO are artificially low due to the partial period dividends paid in the third quarter. Each REIT acquired a peer and paid out a partial dividend. The result is distorted numbers in most screening tools. We intentionally incorporate this data so that we don't forget about it. Sadly, the inaccurate data on yields can impact share prices. We want to remain aware of any inaccurate data that might be widely accessed and used in decision-making.

We usually provide a few ratings in the public release. This week we’re making an exception and providing several of them. It is important to point out that a rating of “buy” should not be confused with saying that the dividend is covered. It doesn’t mean that. A rating of buy simply means that we believe the current share price is attractive. We use the common shares of these mortgage REITs for trading, so looking at expected short-term price movements is very important. Dividend sustainability is important as well, but most residential mortgage REIT dividends are going to be under pressure. Investors focused on income should be focused on the preferred shares rather than the common shares.

Analysis on a few shares

In this section we’ll pull the commentary we had on a few of the shares:

EARN: Ellington is down to .79 on price-to-book. They usually trade at a large discount but they hedge to an exceptional degree. They are useful for buying around the .82 or lower and then selling around .86 or higher. This is clearly in the buy range.

MFA: MFA Financial is in the buy range at $7.04. Who would've seen that coming? This is a great mortgage REIT but the price has almost always been beyond what we were willing to pay. Price to book around .93 to .94 sounds like a viable margin for safety. They have the ability to trade above book value. This REIT focuses on credit risk rather than duration risk and management is very competent at evaluating credit risk.

ORC: Orchid Island Capital is a buy? Yeah, you heard it here. ORC dramatically changed their portfolio mid-quarter. Before the rapid increase in rates started, they reduced their duration risk. How low did it go? They actually ran with NEGATIVE duration going into the period of rising rates. They might well declare an increase in book value for Q3 2018. This is the only agency mortgage REIT where we see that as a possibility. We don't know if they changed again during the storm, but we know they entered the period of rising rates with negative duration. We're estimating price-to-book around .86.

Conclusion

Our bearish outlook has ended for several of the mortgage REITs. A fierce decline in share prices easily exceeded the damage to book values. The result is dramatically better valuations that provide investors with some margin for safety. The margin isn’t huge, but it is present. This is a margin of safety we hardly ever saw in the prior 24 months.

The "Quick and Dirty" series on mortgage REITs comes from another series we run for analyzing mortgage REITs. The other series is "RapidFire mortgage REITs". The RapidFire series includes outlooks, commentary, and additional information in the charts. The RapidFire also included commentary on every mortgage REIT shown in the chart (except IVR). It is exclusively available for members of The REIT Forum. We pick a couple of shares to highlight from that series when we are preparing our public release for the "Quick and Dirty" series.

Disclosure: I am/we are long CMO, DX, ORC, and several preferred shares from mortgage REITs. 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.