1 Thing Every Investor Needs to Do Before Buying a Mortgage REIT

A mortgage can be a great income investment. But don't even think about buying Annaly or American Capital Agency without digging in to this first.

Apr 23, 2014 at 7:36AM

Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) are the undisputed titans of the mortgage real estate investment trust (mREIT) universe, each having the biggest portfolios on the block. Because of this -- and their 10% plus dividend yields -- these companies garner a ton of attention.

While the incredible double-digit yield are alluring, you'd never buy a car without checking under the hood, right? mREITs live and die based on the quality of their assets. So, if there's one thing every investor needs to do before buying an mREIT, it's a dig into the company's assets. Luckily for you, I've done just that. 

The most important asset 
Annaly and American Capital Agency basically do the same thing: buy residential housing debt in the form of mortgage-backed securities, or MBSes from agencies such as Fannie Mae and Freddie Mac. Because Fannie and Freddie guarantee their loans in case of default, these are consider the safest MBSes. 

At the end of 2013, Annaly and American Capital Agency owned $70.4 billion and $64.5 billion of agency MBSes, respectively. This accounted for approximately 86% of Annaly's total assets, and 85% of American Capital Agency's total assets. The vast majority of which are "pass-through" securities. Meaning, the owner of the bond possesses the entire mortgage, and will receive payments from both interest and principal. 

Fixed-rate versus adjustable rate
Pass-through securities come in two different flavors: fixed-rate and adjustable rate. When interest rates are rising or falling, the interest rate on a fixed-rate securities will remain the same, while an adjustable rate MBS will follow the overall interest rate environment up to a certain limit -- what's called a "cap rate." Approximately 95% and 98% of Annaly and American Capital Agency's pass-through securities have a fixed-rate. 

What makes MBSes different?
Even though about 85% of Annaly and American Capital Agency's assets appear to be identical, the profitability of these can be completely different, depending on duration. 

Because interest rates can effect the value of a company's securities, they are among the chief risks for mREITs. Longer-term securities are at the greatest risk -- but also have the great yields. Short-term securities, since they mature faster, have a lower yield and thus less interest rate risk. 

What you'll see in the chart below is a movement by both to a Goldilocks situation: short-term MBSes don't have enough yield, long-term MBSes have a little too much risk, but three-to-10 years is just right.

MBS Portfolio by Weighted Average Life: 2013 (2012)
CompanyLess than 1 year1-5 years5-10 yearsgreater than 10
Annaly Capital Management 0.1% (1%) 71% (96%) 21% (2.5%) 8% (0.2%)
American Capital Agency  0.2% (0%) 38% (34%) 59% (64%) 3% (2%)

How the duration mix of assets changes over time is also important. For instance, mREITs faced a volatile interest rate enviroment in 2013; subsequently, Annaly and American Capital Agency reduced their total MBSes by approximately $50 billion and $20 billion, respectively. 

To reduce its exposure to rising interest rates, American Capital Agency allocated a slightly greater percentage of its MBSes into shorter-term, three-to-five year, securities than the previous year, while Annaly, perhaps because of its significantly reduced portfolio size, moved into more five-to-10 year securities to capture more yield. 

Other agency MBSes
As mentioned earlier, the majority of Annaly and American Capital Agency's portfolios are made up of MBSes. The other 15% gets a little messier, and it varies significantly between the two companies.

As the chart below shows, the two largest (non-MBS) assets for Annaly are $3 billion in agency debentures – which is debt issued by government agencies – and $1.6 billion in commercial real estate. In 2013, Annaly acquired a commercial real estate group, CreXus. As a result, forward looking investors should expect commercial real estate to become a more important complemen to MBSes.

Chart Annaly

American Capital Agency's most important non-MBS assets are its $4 billion in U.S. Treasuries, and $2 billion in reverse repurchase agreements. Repurchase agreements, or REPO loans, are a form of collateralized loan mREITs use to buy MBSes. A reverse REPO means American Capital Agency is acting as the lender.

The two companies also use derivatives instruments to protect against MBS losses. Depending on whether the derivatives made or lost money, they'll be counted as assets or liabilities. In 2013, Annaly and American Capital Agency made $500 million and $1.2 billion on their derivatives, respectively. 

3 things to watch
For investors looking to cash in on mREITs double-digit yields, there's nothing more important than understanding a companies asset mix. Forward looking, investors should keep a close eye on total number of securities held, that'll have a big impact on earnings. How MBS duration changes, and how they're using non-MBS assets to boost profits.

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Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 Motley Fool has a disclosure policy.

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