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A Look At Mortgage REITs

|Includes: AGNC, BXP, CIM, CMO, HTS, MFA, NLY, Simon Property Group, Inc. (SPG)
The combination of the market’s sell off in the last four weeks along with the growing pessimism on the part of investors has understandably caused many to become discouraged. Even if that is the case, though, investors might want to resist the temptation to throw their hands up in disgust and stop looking for sound investments. Such investments are still out there. Admittedly investors might have to wait for more opportune times or prices to buy, but then again, it never hurts to look. One area dividend players might want to look is at mortgage backed REITs.

A Quick Review Of What Mortgage REITs Do

Mortgage REITs are structured as real estate investment trusts, or REITs, but unlike those that buy or invest in properties such as office buildings, shopping malls as do Simon Property Group (NYSE: SPG) or Boston Properties (NYSE: BXP), mortgage REITs invest in mortgage backed securities. These can include mortgage pass-through certificates, collateralized mortgage obligations, and other financial instruments such as agency-callable debentures. These instruments represent interests or obligations backed by pools of mortgage loans. The mortgage REITs make their money by employing the spread between the cost of capital they borrow to purchase these instruments, and the interest earned on these instruments. They must pass 90% of this income through to investors.

A High Yield Arena

The mortgage REITs are known for their high yields. Annaly Capital Management (NYSE: NLY) recently was yielding 14.6%, while Capstead Mortgage’s (NYSE: CMO) recent yield was a stunning 15%. American Capital Agency (NYSE: AGNC), MFA Financial (NYSE: MFA) and Hatteras Financial Corp. (NYSE: HTS) are some other notable names in the group. All sport similar yields.

Annaly Capital Five Year Dividend Yield and Stock Price

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Yields Too Good To Be True?

One of the immediate reactions most experienced investors will have is that such yields are too good to be true. After all, we’re still in a low-interest rate environment, one which has seen the S & P historical dividend yield which was usually pegged at 3% to 6% now running at 2% to 4%, or less. Many blue chips yield 2% or 3%. So are these mortgage REITs, sometimes called MREITs, like shaky junk bonds, or like some of the high-yield stocks that just before they capsize desperately throw out an enormous dividend payout to attract any investors at all? Hardly.

Risks And Rewards With MREITs

Since we’re in a very fear-laden market climate, granted, not without reason, investors want to know about risk. Let’s detail some of the potential risks of the MREITs. They are leveraged, for one. In order to generate the kind of revenue that allows the rich payouts, although mortgage rates currently run at around 4% or 5%, the MREITs borrow as much as five or six times the capital they have. Thus they can continue to collect and replenish their investment pipeline, filling up their income stream.

Defaults, prepayments and, yes, higher interest rates can make things tougher for mortgage REITs. If short term interest rates rise too high, the cost of borrowing rises for the MREITs, which will diminish their revenue and earnings. MREITs live off the spread, so the tighter the spread, the more they will be pressured. Also, higher rates, or more accurately, rapidly rising rates, will also affect their borrowing costs and eat into their spread, as the portfolio yield of the REITs likely won’t keep up with the rising borrowing costs when the yield curve flattens.

Credit risk is another risk cited, but this tends to be muted in the MREITS that invest in agency-backed mortgages. GSEs, or Government Sponsored Enterprises, Fannie Mae and Freddie Mac back these mortgages. Yes, we know, there’s plenty of scorn to go around for these weak-sister agencies as well as the standing of the lack of fiscal wisdom for the US government, however, the US government’s guarantee behind these mortgages is still better than not having it. Chimera Investment (NYSE: CIM), a subsidiary of Annaly Capital, yields 17% and isn’t levered like Annaly and most of the other MREITs are, but it invests in riskier non-agency backed mortgages so carries a much larger credit risk.

What About The Downgrade?

After the S & P downgrade of US debt, mortgage REITs took a hit, some of the stocks falling as much as 10% in a day. The specter of higher interest rates immediately put the quietus on the near-term and maybe the longer term future of the sector. The spreads would be squeezed, risks would be heightened, and so on, was the reaction. Then the Fed announced it was going to keep short term rates steady for the next two years, and the situation changed. Mortgage REITs were more than given a reprieve, as they will be able to operate with a much friendlier low-cost capital model until 2013. This is provided the Fed doesn’t renege on its policy or invoke a 1960s style “Operation Twist,” where the Fed sells short-term securities and buys at the long end. This would effectively boost yields on the short end, so this is another thing to watch.

Capstead Mortgage Five Year Dividend Yield and Stock Price

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The Positive Take

We’ve underscored if not overstressed the risks of the mortgage REITs because we don’t want investors, particularly in this difficult market and economy, to underestimate the risks. That said, MREITs can still be a terrific investment. Annaly, Capstead and some of these others are well managed and profitable. Their yields are real. If investors understand the risks and desire the rewards, they can invest carefully. Scale in slowly, in small amounts, spread out your buying, and watch these quarter to quarter as each dividend is paid. Monitor the macro-economic risks, chiefly those to do with interest rates, and you might end up with surprisingly good profits.

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