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We're back to cover 5 more securities in the mortgage REIT sector.
While we mostly cover lower risk securities at The REIT Forum, we do not believe mortgage REITs are suited for conservative investors. Several mortgage REITs have entered the "overpriced" category. Therefore, we recommend investors be very cautious when deploying capital. Overall, the sector appears almost fully valued.
For investors who didn't read our last public mortgage REIT article, we covered some sector-wide factors and broke down Agency RMBS and Agency CMBS.
We also covered these mortgage REITs in the article from 2/20/2019:
AGNC Investment Corp. (AGNC)
MFA Financial (MFA)
New York Mortgage Trust (NYMT)
Granite Point Mortgage Trust (GPMT)
Arlington Asset Investment Corporation (AI)
Today, we will be breaking down mortgage REITs a little bit more so investors can better understand them. Further, we will be covering the following 5 securities:
Source: This screenshot comes from our "Common Share Spreadsheet" tool which is available to all subscribers
We provided a more extensive view of the sector and our top picks in a recent RapidFire update on mortgage REITs for subscribers.
An example of sector factors and price-to-book ratios
In our previous public article on mortgage REITs, we talked about the impact of spreads "widening". We'd like to go over a simple example so investors can better understand how this work.
Imagine a mortgage REIT which can earn 3% on its assets and can hedge debts at 2.5%. The spread between those 2 metrics is 0.5%.
This hypothetical mortgage REIT running leverage at 10x could generate 5.0% (that's 10x0.5%) in their spread income and another 3% on assets financed with equity. That would lead to 8% in income before operating expenses. That doesn't sound very attractive.
On the other hand, if the asset prices went down (yields go up when prices are down) with no change in the hedging rates, then that same REIT might earn 3.5% on assets. In that scenario, the REIT could earn 10% (that's 10x1.0%) in spread income plus the 3% on assets.
To make this simpler, let's put it in a little chart:
This example is pretty extreme, but it highlights the benefit of wider spreads. The downside is that "spread widening" sends book values materially lower. The widening in Q4 was not nearly as large as shown in the example, but the example demonstrates the fundamental point here. When spreads are wider, investors should be willing to pay a higher price-to-book ratio.
As spreads appear to be tightening again in the first quarter, we would expect to have slight reductions to our target price-to-book value ratios. When spreads tighten back up, it increases book value but eliminates the opportunity to invest at the wider spreads.
We still want to use "Price-to-Book" in deciding which mortgage REITs to buy, but we want to modify our target valuation based on the spreads. This is something we regularly do "behind the scenes", so you get a simpler price target for execution.
Why we don't invest in mortgage REITs more often
We view mortgage REITs as carrying a significant amount of risk. We run a defensive strategy in our portfolio that generally focuses on less risky securities. When we do invest in mortgage REITs, it's with the intent to trade them.
The average yield on our picks is much lower, but the balance sheets are much stronger. We invest with the premise that a recession might be coming at any point. We can't afford to simply sit on the sidelines with cash for years waiting for it to happen, but we can focus on picking more defensive companies that lose substantially less if a recession does hit. We can also defend the portfolio by using higher credit-quality preferred shares when the markets are looking more expensive. They still offer a great yield and they don't decline near as much if things suddenly turn ugly.
We communicate our safety ratings for each stock we cover by assigning a "risk rating". This comes after we review all the fundamentals and review the market's perception of risk for the stock. In some cases, the market perceives a different level of risk than is genuinely present, so we want to account for that. If shares sell off much harder than they should, we want to keep an eye on shares of that stock when the market gets scared because we know there is a higher probability of getting a great entry price on it.
Let's jump into several mortgage REITs.
ARMOUR Residential REIT (ARR) runs a portfolio with a mix of agency, non-agency, and CRTs (credit risk transfers):
For investors interested in these assets, you've got other options for where to get it. We see this with Ellington Residential Mortgage REIT (EARN) and Dynex Capital (DX) for exposure to agency securities.
MFA Financial (MFA) is a top REIT for non-agency exposure on residential lending. An investor could mix and match shares of the 3 REITs as an alternative to ARR.
ARR's latest monthly portfolio update shows a relatively low level of leverage:
The footnote is important. The position in "TBA dollar rolls" (henceforth referred to as "TBAs") is significant. It is very similar to owning the underlying security when it comes to duration risk.
Why is leverage so low in the slide? Because ARR's "leverage" metric included preferred equity as part of their "equity". It also excluded the implied leverage from the TBAs (you can see the TBA positions on the first ARR slide).
Consequently, the total risk to shareholders of ARR is much higher than they might imagine.
Our view on ARR is neutral at recent prices. We have been bearish for a while, but ARR announced issuance of additional common stock which helped bring it down. Then, ARR upsized its public offering and shares dropped again.
It is down enough to take our bearish rating off. Here is a 1-month chart showing what happened after their announcements:
Cherry Hill Mortgage Investment (CHMI) extensively uses MSRs (mortgage servicing rights):
The MSRs are also referred to as servicing related assets. They represented about 14% of the total asset base as of the quarter end.
MSRs have a trait referred to as negative duration. Negative duration means that the asset increases in value when interest rates go up. If we see increasing interest rates, we would expect CHMI to outperform the vast majority of its peers.
We have a bearish rating on CHMI. Recently, we had some commentary on CHMI's poor decision to issue equity below book value.
We like the portfolio composition, but the current share price is too high. We would expect management to be eager to issue additional shares. Without a substantial discount to book value, investors in CHMI simply do not have the necessary margin of safety for investing in residential mortgage REITs.
Chimera Investment Corporation
Chimera Investment Corporation (CIM) is a relatively unique mREIT. They focus on residential mortgage-backed securities. However, they put a huge emphasis on securitizations:
The company has both agency securities and non-agency securities. The non-agency RMBS is one portion of their credit portfolio. Most mortgage REITs focused on credit risk for loans on residential property would allocate most of their equity into non-agency RMBS. CIM is unique because they emphasize the securitized loan portfolio.
We consider CIM to be a well-managed mortgage REIT, but we believe that the price is significantly too high relative to their peers. Even though they have been managed well, some of their peers have also been managed well. Further, their peers don't command the same high valuation that CIM does. Our valuation is based on price to estimated tangible book value as of February.
Capstead Mortgage Corporation's earnings commentary
Capstead Mortgage Corporation (CMO) holds pretty much nothing except for ARMs (adjustable-rate mortgages). Due to the flattening of the yield curve, they have slashed their dividend repeatedly. When the curve flattens, that is exceptionally bad for CMO's earnings.
Capstead Mortgage Corporation's quarter ending BV ($9.39) was higher than expected by a couple percentage points. Looks like a big buyback at a huge discount fueled most of the difference. Buybacks added $.14 to book value per share (weighted average buyback price of $7.47). The extra $.14 in book value warrants higher valuation, all else equal. We also consider the shape of the yield curve and the impact it has on future prepayment expectations in setting our price targets.
Despite the strong book value, CMO "missed" on EPS. Because of how we model for portfolios and look at the accounting, we believe the BV beat is dramatically more important than the weak earnings. The market appears to agree and shares of CMO rallied dramatically. They are now firmly inside our neutral range.
CMO - ending our buy rating
We had a buy rating on CMO for a while and called it out several times for subscribers of The REIT Forum. We also had a public article on 10/29/2018 and a public article on 11/11/2018 where we had a buy rating on CMO's common stock. However, the stock has rallied significantly and is now in our neutral range:
Source: Seeking Alpha
The reason for the change is the price has rallied quite dramatically and the fundamentals have not changed very materially. With fundamentals similar to what we have today, it was a great deal at a much lower price and with today's fundamentals and today's price, it is now a mediocre deal.
Ellington Residential Mortgage REIT
Ellington Residential Mortgage REIT (EARN) is one of the more attractive options. Shares are slightly outside our buy range, though EARN has also spent quite a bit of time inside the buy over the last several months. The discount to book value remains significant. We would expect buybacks around a discount of 18% to 20%.
Ellington Residential Mortgage REIT is far from our favorite mortgage REIT. They run a little heavy on leverage, have a more complicated portfolio, and are externally managed. On the other hand, they hedge harder against duration risk, so the portfolio's net asset value should be less exposed on average to losses in BV when rates increase. They've also been buying back shares regularly because of the substantial discount to book value. EARN regularly trades at one of the largest discounts to book value. However, today, the price-to-book is about .91. For comparison, the average for their residential mortgage REIT peers is about .98.
Consequently, we think the difference in price-to-book ratios is a bit larger than it should be. Further, we find the choice of assets to be intelligent given the movements in valuations:
Most mortgage REITs with an asset labeled "non-agency RMBS" have those assets from quite some time ago. Based on old historical costs, the yields on them are very appealing. That is great for showing high levels of net interest income, but book value already includes the benefit of the market revaluing those securities higher.
The mortgage REIT sector has bounced back dramatically since late December when almost everything was on sale. Given the solid bounce, we've sold a few investments since then for healthy profits.
Several mortgage REITs have entered the "overpriced" category. Therefore, we recommend investors be very cautious when deploying capital. Overall, the sector appears almost fully valued.
In this article, we covered 3 mortgage REITs that are trading in the neutral range and 2 in the bearish range.
While most of our coverage is on REITs with far less than average risk, The REIT Forum still recommends diversifying. We invest the substantial majority of our portfolio in REITs and preferred shares. We suggest that investors choose a maximum allocation using our risk ratings combined with their risk tolerance. Each of our risk ratings connects with a suggested maximum allocation. The maximum allocations generally range from 1% for higher risk options to 6% for our lowest risk choices. By diversifying among these choices, investors can build a portfolio with a less volatile value and more consistent dividend growth. We have purchased many mortgage REITs over the last few years, but we usually buy with the purpose to sell after a rally. We do not believe mortgage REITs are a good fit for the more conservative investors.
The REIT Forum is the #1 rated service on Seeking Alpha. We focus primarily on defensive investments with high growth potential. It is our objective to find quality investments at a discount, along with trading opportunities for the more active investors. Most of our research is on companies that are excellent investments over the long term.
Disclosure: I am/we are long AGNCB, AIC, CMO-E, DX, MFA-B, NYMTN. 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.