9 REITs Ready To Jump Higher In 2013

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Includes: AGNC, ANH, ARR, CIM, CXS, HTS, IVR, NLY, TWO
by: Cris Frangold

The changing nature of the financial industry could give mortgage real estate investment trusts, which are also known as mREITs, a much brighter future than you might think. These vehicles are liable to be around and paying out dividends for far longer than many people assume.

It is changes in the financial markets that have been fueling the growth of REITs like American Capital Group Agency (NASDAQ:AGNC) and Anworth Mortgage Asset Corporation (NYSE:ANH). These companies are growing because nobody else seems to be financing or refinancing mortgages these days. Banks have limited their involvement in the mortgage industry and other players are leaving.

The mortgage market could contract even further, as the Volker Rule and the negative publicity from the losses at JPMorgan Chase (NYSE:JPM) scares bankers away from derivatives. Nobody wants to be seen packaging or repackaging mortgages, but people still need their homes and office buildings financed and refinanced. That provides the opening for the mREITs, which are willing to do the job nobody else is.

Regulation could drive more customers to mREITs, and so could efforts to break up big banks. Proposals to revive the old Glass-Steagall Act, which limited how banks could invest, are floating around. The Chase debacle is likely to renew the calls to break up the big banks or at least force them to sell off assets. If that happens, one of the things the banks jettison could be mortgages. REIT operators will be there to pick up the pieces and profit from them.

The biggest beneficiaries will be those mREITs that invest in non-guaranteed mortgages, such as Crexus Investment (NYSE:CXS) and Chimera (NYSE:CIM). Banks that are afraid of regulation will stay away from non-guaranteed paper. Expect the non-guaranteed mortgage REIT stocks to go way up if Uncle Sam starts aggressively enforcing the Volcker Rule and politicians start talking about limiting bank sizes again.

Okay, it is obvious that the mREIT business is posed to grow, but it is also safe to assume that the double-digit returns we have seen from trusts as diverse as Annaly (NYSE:NLY) and Two Harbors (NYSE:TWO) will stop. That means these companies will see a drop in value at some point in the near future because much of their appeal has been the big dividends. Yet, they still could be good buys because the business is fundamentally sound.

Reforms failure mREIT's opportunity

Part of the reason why it seems to be sound is that the federal government has failed to sort out the mortgage mess. Efforts like President Obama's HARP (Home Affordable Refinance Program) have failed to make a dent in the problem because their creators failed to tailor them to suit economic realities. Many of the homeowners most in need of refinance cannot qualify for HARP. Future political fixes are not likely to be much better, meaning that people in need of refinance will need to turn to the private sector and mREITs.

A successful mortgage fix from Washington is unlikely because of the political grid lock there. In addition to their ideological differences, neither Democrats nor Republicans want the other party to be able to take credit, for one. The only possibility of real action on mortgages would be if one party controlled the Presidency and both houses of Congress. That is extremely unlikely, so expect the status quo in the mortgage market to remain for quite some time.

It should be noted that some mortgage reforms might actually help mREITs. National standards for mortgages and mortgage brokers would make the market more stable and secure. Stricter controls would limit volatility and the risks that some of these institutions are taking. Increased regulations could also drive more players out of the mortgage business, which would increase the potential market for mREITs.

Although effective national mortgage reform is out of the question, there is a way that politicians could hurt mREITs. By simply talking about it, they will scare some investors off and drive stock prices. One REIT that could be badly hurt by that would be Two Harbors, which is heavily invested in the housing market. More conservative mREITs, such as Hatteras Financial (NYSE:HTS), should keep their value during the political season because they buy guaranteed paper.

Interest rate danger could be overstated

Now, rising interest rates could hurt some REITs, but not as much as you think. There would still be a lot of room for companies, such as like Invesco (NYSE:IVR) and Armour Residential (NYSE:ARR), to make money with slightly higher interest rates. They would simply make less money, i.e, their dividends might go down to 5%, which is still a very healthy return for a dividend stock.

These companies would make less because they would have to pay more for money. Since there is no indication that interest rates will go up anytime soon, even this possibility is limited. My guess is that the low interest rates will stick around for at least another year, so we can expect at least one more year of super-high mREIT dividends. That also means higher stock prices and earnings per share.

What we have to remember is that the mREITs will still have a pretty good market for their products with or without low interest rates. People will still need mortgages and mortgage issuers will need financing. If banks stay out of that market, there will be a growing demand.

One thing about low interest rates that would hurt mREITs would be a loss of leverage. The low-interest rates make it easier for them to borrow so they can raise more money faster. Higher interest rates would make it a little harder and more expensive to borrow money, not impossible.

The beneficiaries from higher rates would be bigger and more mature mREITs, such as Annaly, which will still be in a good position to borrow money. These institutions could also reach the size where they are able to self -finance at some point, which would give them an even bigger advantage. They would still be able to leverage assets even if interest rates went up. The question would be if regulators would allow this or not.

The bottom line is that mREITs have a growing demand for their product and a fairly stable source of financing for the foreseeable future. They will continue to grow even if their dividends and earnings per share fall, which is bound to happen. These stocks will come down to earth at some point, but some of them will continue to be a good investment.

Expect an mREIT shakeout

There will have to be a shakeout in the mortgage REIT market at some point. New mREITs seem to be popping up every day, and many of them are taking unusual risks. This shakeout will probably occur when interest rates go up and some of the smaller players, such as CYS Investments (NYSE:CYS), find themselves unable to leverage enough financing.

Expect the bigger more established mREITs to keep growing and some of the smaller less capitalized ones to collapse at that point. In the long run, such a shakeout might be good for the industry because it could reduce volatility. One of the big benefits from a shakeout would be consolidation, which would create stocks with long -term growth potential.

So it is obvious that mREITs have a future and that future is going to be much brighter than the bears are saying. This business model looks like it is here to stay and so are some of these stocks.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.