Quick And Dirty mREIT Discounts For 03/02/2020
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 03/02/2020 after the market closed. Trailing book values are as of 9/30/2019; our subscriber version of this article uses estimates of current book value.
- The public Quick and Dirty series will use BVs from 9/30/2019 until each mortgage REIT covered in the series has reported earnings for Q4 2019.
- Looking for a helping hand in the market? Members of The REIT Forum get exclusive ideas and guidance to navigate any climate. Get started today »
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) | American Capital Agency Corp. |
(AI) | Arlington Asset Investment Corporation |
(ANH) | Anworth Mortgage Asset Corporation |
(ARR) | ARMOUR Residential REIT |
(CHMI) | Cherry Hill Mortgage Investment |
(CMO) | Capstead Mortgage Corporation |
(NLY) | Annaly Capital Management |
(ORC) | Orchid Island Capital |
(DX) | Dynex Capital |
(CIM) | Chimera Investment Corporation |
(EFC) | Ellington Financial Inc. |
(IVR) | Invesco Mortgage Capital |
(MFA) | MFA Financial Inc. |
(MITT) | AG Mortgage Investment Trust, Inc. |
(TWO) | Two Harbors Investment Corp. |
(WMC) | Western Asset Mortgage Capital Corp. |
(NYMT) | New York Mortgage Trust |
(NRZ) | New Residential Investment Corp. |
(PMT) | PennyMac Mortgage Investment Trust |
(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 are using the total book value per share under GAAP. It includes intangible assets, but those are relatively rare. The notable inclusions are for AGNC and NYMT, both of which have “goodwill” from buying a company which was externally managing all, or part, of their portfolio.
We also correctly handled preferred equity. If you're seeing a value that is dramatically different (in some other tool) 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.
Current Outlook on Macro Factors
Prices and book values have been swinging rapidly over the last 8 days. We’re taking a cautious approach. COVID-19 may not be the end of the bull market, but it is more dangerous than any of the other market scares from the last 4 years.
When we were writing this same column about two weeks ago, we had most of the sector in the bearish range because the price-to-book ratios were so high. Since then, we’ve seen a combination of declining book value (due to Treasury rate movements) and declining price-to-book ratios (due to some fear entering the market).
Interest Rates
Interest rates are low. Really low.
Prior “low” rates can’t hold a candle to these. If this continues, we’ll need to consider articles that tell investors to look at refinancing their mortgages to get a lower rate.
That’s a challenge for mortgage REITs. When long-term rates fall rapidly, we usually see book value decline and prepayments on mortgages increase. The mortgage REITs may benefit from cheaper financing costs within the next few quarters, but the fall in rates could put significant pressure on the top line.
Have Rates Ever Fallen Like This?
Silly question. We saw rates plunge, though not this fast, through August of 2019.
Do you know what happened to share prices between November 2018 and August 2019?
It looked like this:
The mortgage REITs got pounded. It was a beating. The chart runs from Halloween 2018 through August 31st, 2019. That’s what the sector looks like when interest rates are plunging.
What do the news stories look like? I’m glad you asked:
(Source: Seeking Alpha)
Investors in residential mortgage REITs want interest rates to remain roughly unchanged, with a very gradual steepening of the yield curve. Instead, rates plunged.
What to Expect
If we don’t see interest rates rally hard over the next month, then Q1 2020 results should show an increase in amortization expense. If rates remain low, prepayments should spike higher in Q2 2020 and Q3 2020. That’s not a good environment for mortgage REITs.
We are still quite comfortable with the preferred shares. We are particularly interested in some of the lower-risk preferred shares, which went on sale over the last week.
Quick Rating Update
We will toss in a few of our “index cards”. These contain the vast majority of the most important information for evaluating a REIT. It gives investors a quick glance at the factors that are important, so it is easier to understand our view. These cards also use very recent estimates for book value per share, rather than using the trailing value.
(Source: The REIT Forum)
(Source: The REIT Forum)
We’re also bearish on the major ETFs, REM and MORT.
We recently reduced our exposure to the mortgage REIT sector. We haven’t taken it to zero, but it is running much smaller than in prior periods. We saw today’s rally as a viable opportunity to reduce positions as we reallocate into an even more defensive position.
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 9/30/2019.
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.
Conclusion
When we place these trades, we’re using more than the trailing book value. We utilize estimates from Scott Kennedy on the current book value per share. Those estimates give us better information on where the value is today, rather than relying on past values. We’re thrilled to have Scott Kennedy joining The REIT Forum as a key author for the service. Our ratings and outlooks on REITs will generally have an enormous amount of overlap, since he handles so much of the fundamental research for The REIT Forum.
We’re not suggesting mortgage REITs for the buy-and-hold investors due to the risk from swings in interest rates. However, we do enjoy buying mortgage REITs when they trade at exceptionally large discounts to book value. The strategy has been exceptionally successful for us because it capitalizes on having superior information on book value estimates and knowledge of historical price-to-book ratios.
Ratings in this article: Bearish on REM, MORT, AGNC, and CIM.
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This article was written by
Colorado Wealth Management is a REIT specialist who began his decades-long investment career in a family-owned realtor office before launching his own company and embracing his drive for deep-dive REIT analysis. He holds an MBA and has passed all 3 CFA exams. He focuses on Equity REITs, Mortgage REITs, and preferred shares.
He leads the investing group The REIT Forum. Features of the group include: Exclusive REIT focus analysis, proprietary charts and data models, real-time trade alerts posted multiple times a month, multiple subscriber-only portfolios, and access to the service's team of analysts and support staff for dialogue and questions on the REIT space. Learn more.Analyst’s Disclosure: I am/we are long ANH, AIC, IVR-C, MFA-B, TWO-D, NLY-F, ARR-C, AGNCP, NLY-I, CMO-E, MFA-B, AGNCO, MFO. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (21)
On January 11th, 2019, HighYieldKing writes:
"A bit of short covering for RAIT. Glad I bought more RASF at 70 cents a few weeks ago."So what happened to RASF? How could it be down over 99%?In an article from September 6th, 2019, Paolo Gorgo writes:
"Last Friday, RAIT Financial Trust (OTCQB:RASF) (OTCPK:RASFQ) filed for Chapter 11 - just ahead of a long weekend, and on the exact day its 7.125% Notes (RFTA) were due for redemption."So this second investment in RASF is also a pretty much total loss. That's two investments, assuming those were the "only" buy dates that went to roughly $0. I've had a few calls that didn't work out great, but nothing going to $0.We had the opportunity to pick RASF also. However, instead of telling investors to buy it, we wrote:
"This REIT's Common Dividend Is Garbage, Preferred At Risk".
seekingalpha.com/...We followed that up with:
"RAIT Financial Trust and the Dead Dividend Walking".
seekingalpha.com/...Those aren't the meanest quotes about RASF in those articles, they were the titles. We went for the jugular with quotes like:
"All consolidated revenues cannot cover interest expense, property management costs, real estate operating expenses, compensation, and other G&A. With no extraordinary items, such as the provision for loan losses, the IRT internalization, or shareholder activism expenses, the income statement would be at a net loss before accounting for a single cent going to a preferred shareholder.The problem with RAS isn’t simply the balance sheet showing negative common equity - it is recurring losses that are built into the operating structure. This isn’t a simple fix, because the problem is at the very heart of the REIT."The article went on to say:
"I began looking into RAS because a subscriber inquired about it. Within the first couple hours, it became clear to me that the common was most likely going to end up in the garbage heap. Common equity already is negative, and we haven’t even started giving out bonuses for demolishing shareholder wealth (payments due on termination without “cause”). A look at the income statement indicated that even preferred dividends were unsustainable. If the preferred dividends were cut, the company could survive much longer. Instead, they are still paying them and declared a common dividend. The covenants on the baby bonds were designed to prevent this, but those covenants were later changed.RAS appears headed for bankruptcy fast. They can forestall it for quite a while if they slash their cash outflows, such as common and preferred dividends. Another analyst believed RAS might have much better income statements in the future, but his analysis kept the consolidated revenues while ditching the associated expenses. I do not believe that is remotely probable. I do not believe the company can monetize existing positions for enough capital to leverage into recreating the same level of revenues through the new platform."That was in August 2017, it was about 6 months before you purchased your FIRST position. So you had access to our research but decided to ignore it.It's not like the analysis was particularly hard. We pulled out the income statements for each article and demonstrated how RASF couldn't make money. We even used bright colors to draw on the income statements as we explained the fatal flaws.We wrote:
"For common shareholders to expect a dividend, net interest spread income needs to exceed $50 million per year. That is the minimum level necessary to cover the company’s targeted annual operating expenses of $25 million plus $25 million in preferred dividends. As of the second quarter, the annualized net spread income would’ve been less than $18 million."So your position was buying into a mortgage REIT with net spread income which couldn't even cover paying management and with negative book value. That's the expertise you're offering to my readers as you critique my work.This will be my copy and paste response to your comments from now on.
