For income investors with a strong stomach and a desire for double digit yields, mortgage REITs, or mREITS for short, pose an enticing proposition. Though the “REIT” moniker gives off the impression that one is investing in tangible real estate, mREITs are typically structured akin to highly leverage bond funds and rarely, if ever, own traditional real estate facilities.
Though the quarter to quarter workings of an mREIT can be somewhat convoluted, the way in which they generate their yields is fairly simple. Mortgage REITs invest in mortgage backed securities, typically of a residential nature (RMBS), but sometimes of a commercial tilt (CMBS). Those residential securities throw off a typically low stream of interest income, but the mREIT is able to ratchet up overall portfolio yield with aggressive borrowing practices.
Generating Elevated mREIT Income
To understand the economics of the mortgage REIT a bit better, take a look the following chart provided to its investors by American Capital Agency (AGNC), a mortgage REIT that only buys securities backed by government agencies or government sponsored entities.
Asset yield is the blended rate of return being generated by the agency securities owned by the company. Cost of funds represents the amount that AGNC is paying on its borrowings. The “spread” is the difference between the two which is then multiplied by the amount of leverage being employed, which, as we can see in the chart, varied between 5.9x (times) and 7.8x over the past year. The product of the spread and the leverage, addition of the original asset yield, and backing out of management fees and other expenses provides us with a net income number.
So on a quarter to quarter basis, the income generated by a mortgage REIT can vary substantially due to variations in asset yields, borrowing costs, leverage employed, and expenses, amongst other factors. The erratic nature of an mREITs income stream as compared to a more traditional brick and mortar REIT lends to inconsistent and unreliable, albeit typically high, levels of dividend income. Thus, investors seeking a necessarily level stream of quarterly income won’t typically find it in this space.
While the amount of income being generated by an mREIT is an important area of focus, another focal point is an mREITs ongoing book value, generally representing what the company is worth once all its assets and liabilities are taken into account. In the below chart we can see that AGNC lost almost 25% of its stated book value in 2013, as its securities lost value amidst interest rate upheaval and general portfolio volatility.
However, how the market may value a mortgage REIT on an ongoing basis can be much different than the company’s actual book value. As we can see in the below chart, for the first quarter of 2013, the market valued AGNC at a premium to net asset value, but quickly swung to a discount following the Fed’s May “taper” announcement. Thus, investors should consider the overall value of the company’s book of business in addition to the amount of income being generated on a periodic basis.
mREITs Going Forward
While the group is unquestionably cheaper than it was a year ago, forward performance will be predicated on interest rate movement. A low, stable interest rate environment represents an optimal operating climate for mREITs, with the opportunity to reap steady security income amidst calm portfolio valuation. If the rate environment becomes choppy to the upside once again, book values and income generation will be volatile, and investor returns will likely suffer, as they did in 2013.
All in all, mREITs embody an exceptionally aggressive income investment not suitable for widows & orphans or others with a more sensitive need for steady, dependable cash flow sources and/or capital preservation needs. For the more adventuresome or those not opposed to the possibility of ongoing volatility, mREITs can be a way to juice overall yield and garner total return in a stable or declining interest rate environment. Still, despite the temptation of robust yields, given the obvious risks, I would advise not to take too big of a bite out of the mREIT apple.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.
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