2 New Entrants for the Market's Hottest Dividend Sector

Huge yields have made the mortgage REIT sector a favorite for dividend investors. The sector is expanding as two new mortgage REITs are completing IPOs: Orchid Island Capital and Apollo Residential Mortgage (Nasdaq: AMTG). These will be the second and third mortgage REIT IPOs completed, following AG Mortgage (NYSE: MITT), of the seven that were filed in the spring. Of these two newbies, one is worth watching, while investors should avoid the other.

Avoid Orchid Island Capital
TheStreet.com's Debra Borchardt has raised numerous red flags on Orchid Island, including:

• A history of lawsuits against the company's management
• Conflicts of interest between the company and its manager
• Multiple name changes and a delisting of its manager

Investors are shying away from the IPO, which was supposed to be completed Friday. In response, the share offering was cut in half and the IPO postponed until later this week. Click here to read her article.

1 to watch
Apollo Residential Mortgage looks interesting. The company is a mortgage REIT and will be managed by ARM Manager, a subsidiary of Apollo Global Management run by the famous Leon Black. Mortgage REITs make money by borrowing money and then using that money to buy mortgage-backed securities. The companies make the difference between the rate they lend at and the rate they borrowed.

The company will be managed by Michael Commaroto, the CEO-Capital Markets of Vantium Management -- an investor in mortgage backed securities -- with support from Keith Rosenbloom on Agency MBS and Paul Mangione on non-Agency MBS.

Initially, Apollo Residential plans on focusing on agency MBS, like Annaly Capital (NYSE: NLY) and many other mortgage REITs do. Apollo believes the Agency MBS market is highly attractive right now as there is a widening spread between Agency MBS and funding for it. Between December 1984 and May 2011, the spread between the two has averaged 246 basis points, but as of March 31, 2011, that was 400 basis points. Apollo plans to take advantage of this spread with a leverage level on a debt-to-equity basis of up to 10-to-1 on Agency MBS assets, which compared with peers is fairly high:

Sources: Company filings, Yahoo! Finance.

As a REIT, Apollo will then distribute the earnings from the spread as a dividend to investors.

One difference from Annaly and other large mortgage REITs is that Apollo sees its focus changing over time. Apollo believes the current level of government involvement in the U.S. mortgage market is not sustainable. In the future, the company sees Fannie Mae and Freddie Mac having less of a role in the mortgage market, leaving opportunity for private investors.

Apollo anticipates a return of an active private non-Agency MBS market. This market reached a peak of $740 billion in 2005, but in 2010 market activity was 99% less at just $5 billion. In the meantime, Apollo believes there will be an opportunity to pick up legacy non-Agency MBS as the market continues to fluctuate. Since the non-Agency MBS market is riskier than the Agency MBS market, Apollo plans to use up to 3-to-1 leverage, which would be high compared to non-Agency investor Chimera (NYSE: CIM), though in line with what AG Mortgage was expecting when they IPO'd.

Sources: Company filings, Yahoo! Finance.

A third area Apollo will focus on will be buying pools of residential mortgage loans that will not be made in securities. These loans have less liquidity than mortgage-backed securities and are often loans that do not meet the size requirements to be backed by the government. Apollo expects to have up to 6-to-1 leverage on these loans.

Course of action
Apollo plans on initially investing mainly in Agency MBS and then slowly diversifying over the next year or two. The company's rough estimate of the portfolio after two years is between 20% to 40% of each of the three categories above and 10% to 20% of other residential mortgage assets.  

Foolish bottom line
We will have to wait for Apollo to build its portfolio to see how much its mortgage will yield. With its top notch management team the company is surely one to watch. We can help you keep tabs on Apollo Residential with MyWatchlist.com, our free, personalized stock tracking service.

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