Beginning of the End for Mortgage REITs?

If you like stocks with the biggest dividend yields in the market, then you have to love real estate investment trusts that invest in mortgage securities. For years now, many mortgage real estate investment trusts have paid double-digit dividend yields while seeing some impressive price gains as well.

But for a while, skeptics have believed that eventually, good times for mortgage REITs would come to an end. Now, news from four of the most popular mortgage REITs has some wondering whether that end will come sooner than later.

The dreaded dividend cut
One fear that some, including my Foolish colleague Anand Chokkavelu, have expressed is that at some point, the extremely favorable conditions that have supported mortgage REIT profits will change. To understand the impact of such a trend change, let me take a break to give you some background on how these investments work.

Mortgage REITs make money by borrowing money, typically at rates based on prevailing short-term interest rates, and using it to buy mortgage-backed securities, whose income payments are generally based on longer-term interest rates. When the spread between short-term and long-term rates is wide, as it has been for some time, mortgage REITs are extremely profitable. When rate spreads tighten, however, profits get hurt. And since REITs pay the bulk of their income in dividends, lower profits mean smaller dividend payments.

That's apparently what happened to Annaly Capital (NYSE: NLY  ) and Chimera Investment (NYSE: CIM  ) this quarter. On Monday, Annaly announced that it was dropping its dividend to $0.62 per share, a reduction of 3% from the previous quarter and down from its high of $0.75 at the end of 2009. Similarly, Chimera also cut its dividend for the second quarter in a row, with a much bigger cut of 18% to $0.14 per share. Chimera shares dropped 4% on the news, while Annaly lost a more modest 1%.

Yet the conditions you'd expect to see in a falling-dividend environment for mortgage REITs don't seem to be present. Short-term rates haven't budged, and long-term rates spent much of the first quarter at higher levels before falling back near their end-of-2010 levels. Moreover, Cypress Sharpridge (NYSE: CYS  ) announced earlier this month that it would hold its dividend steady for the first quarter. Because dividends are a leading indicator of quarterly income in this industry, we should know more when Annaly and Chimera make their next earnings report.

Gimme more shares
Meanwhile, some other mortgage REITs are cashing in on investor interest before it has a chance to evaporate. This week, both American Capital Agency (Nasdaq: AGNC  ) and Invesco Mortgage Capital (NYSE: IVR  ) announced massive secondary offerings, which sent their shares sharply downward. American Capital Agency offered 28 million new shares at a price of just under $28 per share to bring proceeds of $780 million, effectively increasing the size of the REIT by about 30%. Invesco's offering of 19 million shares pushed its share count up by nearly 40% and should raise around $400 million given current share prices. Again, shares of both companies fell 3% to 4% in response to the news.

Secondary offerings aren't new to the mortgage REIT industry, and they aren't automatically bad for investors. Both Hatteras Financial (NYSE: HTS  ) and Two Harbors (NYSE: TWO  ) have announced similar secondary offering during March. But typically, new shares are priced at a slight discount to the prevailing market price, which often causes the share price to drop.

The bigger concern, however, is an overheating market. Most of these companies plan to use their new capital to buy more mortgage securities. At some point, though, as the REITs compete against each other for the best securities, some of them will have to settle for lower-quality investments -- and eventually, that could come back to haunt them.

Don't turn that dial
As long as the Federal Reserve doesn't start hiking rates, mortgage REIT investors probably have some time before any major problems appear. But to make sure you don't miss any important news, you should start keeping a close watch on the mortgage REITs you're most interested in. That way, when you decide the long-anticipated end of the mortgage REIT bull market has finally come, you'll be able to get out quickly and keep your profits.

Get all the updates you need on the mortgage REITs you follow. Add Annaly Capital, Chimera Investment, American Capital Agency, and Invesco Mortgage Capitalto your watchlist.

Fool contributor Dan Caplinger got fooled by the alleged beginning of the end of winter. He owns shares of Chimera Investment. The Fool owns shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy will never end.


Read/Post Comments (17) | Recommend This Article (33)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 24, 2011, at 6:30 PM, wsplitts wrote:

    Motley Fool has been anti-mortgage REITs for the last TWO YEARS. I have made a nice piece of change in that time. There is nothing here that hasn't been said before....and before....and before... and before. This may be the time to pull back, but Motley Fool gets no credit for predicting it over and over again.

  • Report this Comment On March 24, 2011, at 8:00 PM, dbackroyal wrote:

    I could not agree more. This writer has been anti REIT forever and a day while we have made a nice tidy profit with yields and capital appreciation. He is not saying anything that the most novice REIT investor does not already know DUH!

  • Report this Comment On March 24, 2011, at 8:02 PM, revrurik wrote:

    I agree. The Fool has been anti-mortgage REIT's for a while. But that's ok. Even dropping their dividend still leaves it higher than 90% of the market. I'm happy to stick with Annaly for the forseeable future. At least they're not game playing and 'raising their dividend by 20%' - from 5 cents to 6. That's just disgraceful.

  • Report this Comment On March 24, 2011, at 9:51 PM, HectorSector wrote:

    The reason both NLY anad CIM, both run by the same people, cut dividends was that they had issued new shares recently and the new investments they made with that capital didn't generate income immediately. The lag time is a common factor in all expanding MREITs.

  • Report this Comment On March 25, 2011, at 10:24 AM, refriedbean wrote:

    Broken record

  • Report this Comment On March 25, 2011, at 11:13 AM, sailrmac wrote:

    It was nice at least that there was acknowledgement that these REIT's make there money from the spread between short and long term rates not the absolute rate. Frequently they indicate something like "if rates go up, look out below" like it's a foregone conclusion when rates go up the price will decline.

    Anyway, with the fed scheduled to start unloading it mortgage backed securities, I would expect the mortgage REIT's to be big buyers. That is why I expect many are starting to fill up the warchest.

  • Report this Comment On March 25, 2011, at 11:38 AM, fed45 wrote:

    I am a bit of a novice investor. I am curious about NLY's FNMA and Freddie Mac exposure. Is anyone concerned about it given the uncertainty surrounding these two insitutions?

  • Report this Comment On March 25, 2011, at 11:46 AM, bentley4260 wrote:

    Well....I have made money with NLY, last time I checked, going from a 14% dividend to an 11% dividend is not that bad !!!! Duh !!!!!

  • Report this Comment On March 25, 2011, at 3:16 PM, geoflying wrote:

    I don't tink soo, plenty of time left to make money here.

  • Report this Comment On March 25, 2011, at 3:39 PM, frank3773 wrote:

    sailrmac: I may be wrong, but I think "...rates go up look out below..." refers to bond interest rates???

    bentley - agree - if 14% drops, even to 5%-6% range it's still fairly decent/equivalent of any other good div-payer, and plenty of time to be looking for something else to move to, IF you bought in early at a low price. But if you bought recently a drop in dividend rate will also trigger share price drop and capital loss to go with it. Other side of that coin is that a small div drop along with share price decline might be considered a "buying opportunity"...........Frank

  • Report this Comment On March 25, 2011, at 4:53 PM, fed45 wrote:

    Thanks for the feedback, appreciate the help.

  • Report this Comment On March 27, 2011, at 4:46 PM, jtheoldgolfer wrote:

    Mortgage reits have avged 5.85% for the last ten years..Wall st. journal. That is considerably more than my stock ports. managed by PROS. GIVE IT UP FOOL.

  • Report this Comment On March 28, 2011, at 3:58 PM, DR1LLER wrote:

    VERY DISAPPOINTING PIECE. AGNC DOES A SECONDARY OFFERING EVERY QUARTER AND CREATES AN AMAZING BUYING OPPORTUNITY IN THE PROCESS. HARD TO DISLIKE A 19+% RETURN WITH A VERY STABLE STOCK PRICE THAT SEEMS TO INCH ITS WAY UP ALL THE TIME. UNTIL SOMETHING DRASTIC HAPPENS MY DIVIDENDS WILL KEEP ON BEING REINVESTED AND I BUY MORE EVERY TIME A SECONDARY IS OFFERED.

  • Report this Comment On March 30, 2011, at 12:14 AM, surfgeezer wrote:

    Disappointing article. No mention WHY AGNC did not cut divvys and of checking for % mix in Securities for adjustable rate that are stable. Their may be a panic selling at rate hikes but proper selection means a buying opportunity.

  • Report this Comment On April 01, 2011, at 2:56 PM, RoughEdges wrote:

    In order for investment journalism to be useful we need to delve into the math. What's the worst that could happen to $5,000 in a mortgage REIT and what are reinvested results over say 30 yrs compared to for example $5,000 6%, 30 yr bond held to maturity -also reinvested? Since nobody has provided a worse case, let's use a model in Excel. In order to be as bad as a bond, a REIT paying 15% would have to see an annual drop of 9% in dividend rate coupled with an annual drop in stock price of 9% for 30 years. [so first year dividend drops to 13.65 and ends up at 1% after 30 years). Both cases provide $31,678 after 30 years. Price and dividend for the REIT is a dropping curve that levels off and not realistic but it's just a mathematical exercise to show that even if dividend and stock price drop, a high divi stock is a GREAT compounder. Now let's add 4 cycles of volatility: Four 48% drops followed by 93% recoveries over 30 years. The $5,000 REIT return rises to $222,162 (reinvested, buy & hold) even though dividend and price are continually dropping. The trick comes from dividends buying extra dividend paying ATMs while stock price is in the trough. I have not seen this calculation anywhere else but there is a calculator at buyupside.com which is fun to play with and matches my basic numbers.

  • Report this Comment On April 01, 2011, at 3:16 PM, mclaugph wrote:

    I wouldn't say the author is anti-REIT, his disclosure shows he owns CIM.

    Beyond the lower dividend for NLY/CIM, there really wasn't anything new or insightful about this article.

    I'd like to see more research/explanation into why NLY/CIM lowered dividends and other REITs didn't.

    Like many posters, I own some REIT stocks and keep an eye on rates.

    RoughEdges, I haven't run the numbers myself, but if your calculations are correct that's a very interesting comparison...thanks!

  • Report this Comment On April 07, 2011, at 12:40 PM, wsnagle24 wrote:

    This article should be titled "Beware of the Beginning of the End for REITs, which hasn't come yet"

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1464246, ~/Articles/ArticleHandler.aspx, 12/19/2014 1:31:56 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement