Quick And Dirty mREIT Discounts For 8/12/2019

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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

Discounts to book value are a major part of evaluating mortgage REITs.

We use this series to compare the latest share price with the trailing book value per share.

The ideal method utilizes current estimated book values, but using trailing book values is quick, and it still provides enough information to enhance decisions.

Prices are from 8/12/2019 while the market was open. Trailing book values are as of 3/31/2019, our subscriber series uses book values updated for projected change in book value.

Our next quick and dirty piece will incorporate book values reported for 6/30/2019 as the last of the mortgage REITs are publishing their results.

One of the most important steps in evaluating mortgage REITs is finding the price to book value ratios. Using the mortgage REITs' book value gives us an idea for the general range where the mortgage REIT should trade. We expect that all mortgage REITs holding similar assets will generally be correlated with each other.

If you see several mortgage REITs trading at 15% or greater discounts to book value, you should expect comparable mortgage REITs to also trade at material discounts to book value. If a few are trading at premiums, while others trade at huge discounts, it usually represents an opportunity.

The mREITs

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

(AGNC)

AGNC Investment Corp.

(AI)

Arlington Asset Investment Corporation

(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.

Ticker

Q1 Tangible BV

Price

Price to Trailing Tangible BV

AGNC

$17.23

$16.85

0.98

AI

$8.70

$5.76

0.66

ANH

$4.76

$3.67

0.77

ARR

$21.29

$17.37

0.82

CHMI

$17.54

$13.94

0.79

CIM

$16.15

$19.70

1.22

CMO

$9.43

$8.19

0.87

NLY

$9.67

$9.32

0.96

ORC

$6.82

$6.18

0.91

CIM

$16.15

$19.70

1.22

DX

$18.72

$15.54

0.83

IVR

$16.29

$16.45

1.01

MFA

$7.11

$7.37

1.04

MITT

$17.44

$16.04

0.92

NYMT

$5.75

$6.20

1.08

TWO

$13.83

$13.33

0.96

WMC

$10.70

$9.76

0.91

EARN

$12.69

$10.83

0.85

Changes in Book Value

The REIT Forum provides sector updates which utilize the ratios of price to current estimated book value.

Those estimates incorporate the impact of expected changes in book value throughout the quarter. Changes in expected book value come from changes in the fair value assets and hedges, as well as net interest accrual throughout the quarter and the ex-dividend dates.

For the public article, we're providing price to trailing book value, which utilizes the book values as of 3/31/2019. We're still using tangible book value, so assets such as "Goodwill" are stripped out. We believe this creates a much better comparison.

What Did We See in Q2 2019 Reports?

Overall, results were slightly below our expectations. A few mortgage REITs outperformed and a few underperformed. Yet we’ve seen most of the sector punished harshly over the last few weeks, which follows on the back of several months of pain in mortgage REIT share prices.

If results were only a little below expectations, why have prices struggled so mightily?

Interest Rate Volatility

Interest rates have become more volatile and that volatility has primarily headed in one direction. If rates became more volatile on a daily or weekly basis but weren’t showing a clear trend, it would be less of an issue. See if you can spot the trend in this chart for the 10-year Treasury from MBSLive:

Easy enough trend to spot, right? When Treasury rates calm down for a bit, we can see prices in recovery mode. When they become more volatile, we see more pressure on prices.

It wasn’t the Q2 2019 earnings reports that were driving most of the pain, it was the drop in interest rates over the last two weeks.

Outlooks

We’re bullish on Dynex Capital. DX is one of the mortgage REITs which hedged heavily against rates moving lower in Q3 2019, but they’ve seen their share price hammered anyway. While we do expect some damage to book value, we don’t expect it to be nearly as significant as the move in the share price.

We explained our mortgage REIT investing techniques in A Brief Guide to Residential Mortgage REITs:

Share price movements include both a fundamental element and a random (or emotional) element. The best way to think about this is to imagine a human walking a dog.

The human represents the fundamental value.

The dog represents the share price.

Many investors pretend that the leash is short. They imagine this:

However, we’ve found that the leash is quite long.

The human and the dog can become materially separated for a while. The size of the separation can vary quite substantially. Consequently, it can be difficult to predict which direction the dog is going to walk. This causes investors to focus only on the dividend and claim that the path of the dog “is random.” They don’t realize that the sustainable dividend level is also tied to the path of the human.

The best possible scenario for a trader is one where the other investors believe the share price to be random.

The reality of mortgage REIT investing looks like this:

Imagine lower prices to the right and higher prices to the left.

  • If the human turns right, all the dogs are likely to move right.

  • If the human turns left, all the dogs are likely to move left.

  • If the human doesn’t turn, that dog is unlikely to go much further right.

This is the fundamental key at the heart of understanding mortgage REIT price movements. They can appear “random” at times, but they will usually stay within a given range from the fundamental value.

We don’t want to utilize these shares as long-term investments. We can only make very rough predictions about the path the human (fundamental value) will take in the future. We don’t want to risk our money on predicting the path of the human. Instead, we simply want to predict that the gap between the human and the dog will shrink. Whether the gap shrank because of the dog returning or the human taking a step towards the dog, we only care about the size of the gap.

Trading

We see the preferred shares as a superior option for investors hunting for a long-term buy-and-hold investment. The preferred shares carry slightly lower yields but have substantially less risk. Investors who don't care about the risk level are taking excessive risks for very marginal expected returns.

We utilize the common shares as a trading investment because many investors in the sector don't understand how to project current book values or how to evaluate the spreads between mortgage rates and hedging rates. Our outlooks on the common shares should be seen as a view on the potential for trading opportunities.

What Makes Us Bullish on Dynex Capital

DX indicated that they wanted to reduce prepayment risk over the coming years. RMBS (Residential Mortgage-Backed Securities) face a significant risk from prepayments. When interest rates fall, more homeowners decide to refinance their mortgage. The owner of the MBS is paid $100 in principal for each $100 that was refinanced, but the fair value may have been higher (say $102 to $104).

On the earnings call, management highlighted that even “specified pools” (RMBS which tend to prepay at slower rates) would still be subject to prepayments if rates fell much further. To reduce their exposure, they increased the portion of their allocation allocated to CMBS (Commercial Mortgage-Backed Securities):

CMBS are different because they have protection from prepayment built into the contract. That doesn’t make prepayment “impossible,” but it makes it extremely difficult. The homeowner (loan goes into RMBS) is not punished when they refinance. The borrower in a CMBS must pay a significant penalty. By position in CMBS, DX is reducing their risk of elevated prepayments. They still carry some of this risk as fixed-rate agency RMBS remains their largest single position, but they have a very substantial portion of their portfolio within fixed-rate agency CMBS.

DX took high leverage into Q3 2019, but they also positioned the portfolio with a clear consideration for the possibility of rates falling lower. They were less exposed than most peers to a decline in rates, so we would expect the damage to be less significant. That’s the opposite of the recent price action, which makes it a more appealing entry opportunity.

Our Position

We’re long shares of Dynex Capital. We purchased some in August 2018 and some earlier this month. Adjusted for dividends, the returns have been slightly negative on our position. That’s unfortunate, but not completely unreasonable given the enormous drop in interest rates which occurred during that time. When we look at their closest peers, other mortgage REITs investing primarily in agency MBS, we see many of the peers struggled as well.

Disclosure: I am/we are long DX, ANH, ARR, AI, CHMI, AND SOME PREFERRED SHARES. 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.