Are Mortgage REIT Dividends Free Money?

I've written in the past about the risks associated with mortgage real estate investment trusts Annaly Capital Management (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) , and I've become increasingly disturbed by reader comments that make it clear that some shareholders believe mREIT dividends are "free money." As a result, I think it's crucial to dispel a few fundamental misunderstandings about these companies and their stocks.

This is no straw man
If you are among the mREIT shareholders who have a solid grasp on the risks inherent in these shares, you may think this "free money" attitude is purely a straw man position that I have created. To prove that isn't the case, just take a gander at the following comments, which I lifted verbatim from one of the most highly rated bullish CAPS pitches for Annaly Capital: "By ensuring [Fannie and Freddie's] survival, the government ensures that Annaly Capital Management won't go belly up as well. So basically we have an almost guaranteed yield in double digits every year, unless the stock price skyrockets, which wouldn't be bad at all."

I rest my case for the utility of an article like this one.

First reality: There are no barriers to entry in this business
You might think mREITs have a defensible franchise. After all, not just anyone can manage a large portfolio of mortgage securities. Well, yes and no. Yes, managing a mortgage bond portfolio requires knowledge and experience. However, any reasonably established trader fresh off a Wall Street mortgage desk can launch a hedge fund and go head-to-head with Annaly in a matter of months; all you need is some office space, a Bloomberg, and a few signed documents with a prime broker.

Strictly speaking, it's not entirely true that there are no sources of competitive advantage in this area. In theory, a strict value discipline and the ability to adopt a long-term time horizon are the twin pillars of success. I'm willing to believe that Annaly's management has a value orientation (although I think Redwood Trust (NYSE: RWT  ) is a better example of this than either Annaly or American Capital). The trouble is that mREITs lack financial flexibility because they must, by law, pay out 90% of their profits to shareholders, and they depend heavily on short-term financing. That's a huge structural impediment to implementing a value approach -- particularly during periods in which it would be most profitable.

Second reality: Businesses with no moats don't earn excess returns
It's a basic principle of finance: If you have no competitive advantage, you cannot expect to earn excess returns over an extended period of time. Does that mean mREITs have a competitive advantage? Take Annaly, for example, which has delivered an 11.3% annualized return over the past 10 years, smashing the S&P 500's 3.4% return in the process.

Occam's razor suggests to me a simpler, more consistent explanation: mREIT stocks are much riskier than the average equity. Here's another way to think about it: Which of the following two propositions is more likely?

  1. MREIT shareholders have spotted an extraordinary opportunity to earn a low-risk 14-percentage-point yield premium over the 10-year Treasury bond rate (in the case of American Capital). The rest of the market has completely misunderstood the risk/reward proposition these shares represent.
  2. In exchange for pocketing 14 percentage points in yield premium over the risk-free return, mREIT shareholders are bearing substantial risk.

I'm going to go with No. 2 for $2,000, Bob.

Third reality: I'm not against mREITs
I've seen them before, so I fully expect to see multiple comments in the section below accusing me of using scare tactics to keep people out of mREITs. Let me make this clear: I have no emotional or financial interest related to mREITs, and I am perfectly happy for people who invest in them, if that is their wish. However, I believe investors are better off when they understand the risks of their investments. Incidentally, everything I have written here applies equally to mREITs that don't invest exclusively in agency mortgage securities, including Invesco Mortgage Capital (NYSE: IVR  ) and Chimera Investment (NYSE: CIM  ) .

What you need to do now
I don't wish mREIT shareholders any harm -- that's the reason I'm writing this article. However, I fear that a significant proportion of them are "walking around blind without a cane," to quote the infamous Gordon Gekko. I know it's considered quaint nowadays for an investor to read a company's annual report, but if you own mREIT shares (or are considering buying some) and you haven't already done so, I strongly urge you to review the "Risk Factors" section of these companies' most recent 10-K reports. That is the first step you must take if you want to understand what could go wrong with your investment.

If you want to collect dividends that are truly low-risk, get The Motley Fool's free report explaining how to "Secure Your Future With 11 Rock-Solid Dividend Stocks."

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. 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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  • Report this Comment On March 07, 2012, at 3:11 PM, Littlejohnnyd wrote:

    you explain that these REITs are risky but fail to say how the risks would manifest. Is it a sudden rise in interest rates, a futher collapse of home prices, more corruption at Fannie revealed, an act of Congress? Anyone can say "this is too good to be true". Please tell us why. Thanks

  • Report this Comment On March 07, 2012, at 4:00 PM, HighVoltage627 wrote:

    @littlejohnnyd

    One of the primary risks of mREIT's is to their dividend. mREIT's Make money by borrowing short term money at attractive rates, and buying goverment backed loans at higher interest rates. As interest rates climb, their borroing costs will increase, not only for new borrowings, but for rolled over older borrowings as well, this will hurt profitability, which in turn will trigger a dividend cut. A dividend cut will probably trigger a stock price decline.

    As borrowing rates are at rock bottom lows right now, things cant get much better for mREIT's. Inevitably though, interest rates will rise, which will trigger reduced dividends, and stock price losses. IMHO, its not a matter of if, its a matter of when.

    Currently, the Fed is saying raising interest rates is still a couple years away, but, if the economy performs better than expected, theres no reason it couldn't happen sooner. So all it will take to wound mRIET holders is rising interest rates. It doesnt even have to be abrupt.

    There are other scenarios where things could get really bad for mREIT's, but most of them are highly unlikely.

    P.S. Im not against mREIT's either, I'm long NLY, but I too am a firm believer in understanding risks.

  • Report this Comment On March 07, 2012, at 4:59 PM, jkfelton wrote:

    Good Article, I pondered NLY in 2008 and instead went with the reit "O" I just didn't want to be the one holding the bag when the song ends and rates go up which I thought would have been 2010 oops wrong on that call. That said there is an article on fool claiming the next 100years will be bad for houseing so NLY could have be a sustainable vehicle. Just not for me give me sustainable business models every time...

  • Report this Comment On March 07, 2012, at 5:01 PM, TMFAleph1 wrote:

    @Littlejohnnyd

    Have you read the 'Risk Factors' section of Annaly's, as I recommended? It provides multiple scenarios describing how things can go wrong for these businesses.

  • Report this Comment On March 07, 2012, at 5:23 PM, TMFAleph1 wrote:

    I did not mention this in the article due to word count constraints, but, in the course of my research, I came across an observation that I found puzzling. Why is that both Annaly and Redwood Trust's profitability over the past three years has failed to be consistently higher than than their historical average (on the basis of return on assets or return on equity)? I would have thought the last three years has offered ideal conditions for maximum profitability. I only looked at Annaly and Redwood Trust because they are the only mREITs I know that have any significant operating history.

    I'm not suggesting this is evidence of anything specific; it's simply something that I found odd. There may be a perfectly good explanation (I didn't take the time to look for one), but, if I were a shareholder, I'd want to find out what it is. I'd be interested if anyone can offer any insight on this point.

  • Report this Comment On March 07, 2012, at 5:37 PM, sailrmac wrote:

    Risks:

    #1 Interest Rate - The spread between short term rates and long term rates declines. This can happen numerous ways: increasing rates, twists, competition lowers spreads, etc.

    #2 Prepayments - Higher rate mortgages are refinanced into lower rate mortgages. Note if you own the asset for less than book (e.g. bought it for 57¢ on the dollar like one of my mREIT's, or the mREIT itself is trading for less than book) prepayment can also be a benefit.

    #3 Default - For non-agency mortgages this is a real risk. For agency assets this risk is about the same as the risk of US Treasuries defaulting.

    #4 Management - Managers hedge when they shouldn't or vice versa. Managers find ways for majority of the benefit to go to them instead of shareholders.

    Benefits:

    #1 Very high yields

    #2 Low correlation with the S&P500

    Disclosure: long mREIT's

  • Report this Comment On March 07, 2012, at 6:05 PM, jdwelch62 wrote:

    I agree that there is risk, but there is risk in any kind of investing, which warrants due diligence on the part of the investor. Based on Chrmn Bernake's statements about the Fed keeping interest rates at their current levels until the end of 2014 (at least), I've got a 3-year green thumbs up on NLY in my CAPS, but I'm trying to keep a very close eye on Fed announcements wrt the future direction of interest rates. With only one quarter's worth of dividends collected so far, NLY has covered what I paid in commissions, plus what I'll have to pay in commissions when I sell it, so at the moment any more dividend payments go into the "profit" column. I may not be Long on them, but I'm going to hold onto them for the next couple of years, at least, with my finger on the pulse...

    :-)

  • Report this Comment On March 07, 2012, at 6:28 PM, rd80 wrote:

    Alex,

    "Why is that both Annaly and Redwood Trust's profitability over the past three years has failed to be consistently higher than than their historical average (on the basis of return on assets or return on equity)?"

    My guess would be the spread is under pressure at the long end. Short term rates are and have been about as low as they can go, but the interest earned on the MBS has to have declined over the past several years - or the mREITs have been paying a premium for existing paper with the same result.

    Best regards, Russ

  • Report this Comment On March 07, 2012, at 6:52 PM, TMFAleph1 wrote:

    @rd80

    I agree with you that the explanatory factor probably lies at the long end of the curve, but, given historically low financing rates, I would nevertheless expect mREITs to continue earning returns above their historical average.

  • Report this Comment On March 07, 2012, at 7:00 PM, crca99 wrote:

    May I assume there is no perfect parallel between mortgage REITs (loan default risk) and commercial real estate management REITs (lease non-renewal risks)?

  • Report this Comment On March 07, 2012, at 7:15 PM, TMFAleph1 wrote:

    @crca99

    You can safely assume that, yes.

  • Report this Comment On March 07, 2012, at 7:48 PM, awallejr wrote:

    Welp down this road again. For those interested in a longer thread see here:

    http://caps.fool.com/Blogs/this-will-not-end-well/712144

    If you are attempting to simply give generic observations about these investments. OK. But that is all you ever give, aside from pointing to required 10k warnings.

    Talk about the management at NLY. As I have said before if you bought this stock during it's IPO in 1998 (ideally at $6) you received over $25 in dividends. That is a 15 year history. AGNC is much younger so the jury is still out on them, although they did manage to survive one of the worse financial crisis in our lifetimes.

    And Russ gives a good reason for potential lower payouts. It is the long end interest rate that is putting pressure along with re-payments from higher interest rates into lower ones. You might have to lever more, but NLY is very conservative about that.

  • Report this Comment On March 07, 2012, at 8:27 PM, TMFAleph1 wrote:

    <<You might have to lever more, but NLY is very conservative about that.>>

    If by "conservative" you mean "leveraged 7:1 with a near total dependency on very short-term financing that does not match the duration of your assets," then we are agreed.

  • Report this Comment On March 07, 2012, at 8:34 PM, TMFAleph1 wrote:

    <<If you are attempting to simply give generic observations about these investments.>>

    It's true that all mREITs, without exception, share a similar set of genuine, significant risks. That fact should be a cause for concern, not dismissiveness.

  • Report this Comment On March 07, 2012, at 11:43 PM, Merton123 wrote:

    The key to investing in REITs is figuring out what they own. If the REIT owns commercial property then the yield is the rent they charge to tenants. A mortgage REIT is a REIT that owns mortgages. When you have a Mortgage REIT giving 14% return like Annaly Capital Management then you have to ask how can the mortgages be providing a 14% return? The only answer that makes sense is that Annaly must be borrowing money to buy these mortgages which explains the high yield. They are acting like a hedge fund. They have done a good job so far. As interest rates go up on the borrowed money there will be less money to pay Annaly investors. The 14% yield will go down.

  • Report this Comment On March 08, 2012, at 12:16 AM, TMFAleph1 wrote:

    <<The only answer that makes sense is that Annaly must be borrowing money to buy these mortgages which explains the high yield. They are acting like a hedge fund.>>

    Precisely. And the same investors who would never even dream of putting their money into a fixed income hedge fund that uses liberal amounts of leverage invest in Annaly shares without giving it a second thought.

  • Report this Comment On March 08, 2012, at 12:44 AM, awallejr wrote:

    "If by "conservative" you mean "leveraged 7:1"

    Actually I think NLY is under 6 levered, whereas AGNC is under 8. Sure as hell beats those companies that were levered 40-60 times which that then fool of an SEC director Christopher Cox allowed.

    Alex I keep telling you these companies yield over 10% because the market realizes that these yields can't be counted on. That doesn't make them bad investments. NLY already paid for itself 3 times over. Talk about management not theoretical possibilities. Let this go already.

  • Report this Comment On March 08, 2012, at 1:12 AM, awallejr wrote:

    Why cause of concern? It is a risk no different than risking in other companies whose products may wither by the vine. You still refuse to give company specifics. NLY is one of the LEAST levered Mreits. Around 6 times. AGNC is under 8 times. This is a far cry from the 40-60 time leverages that fool Christopher Cox allowed.

  • Report this Comment On March 08, 2012, at 1:33 AM, PoundMutt wrote:

    Thanks to all!

    I now know much more about mREITs than before.

    HOWEVER, I do not understand the income tax treatment of mREIT dividends in taxable accounts versus ROTH IRAs. I have read that mREITS should NOT be held in IRAs. Why is that?

    Can anyone explain in terms simple enough for somebody with an IQ just a little over 100, like me!!!???

  • Report this Comment On March 08, 2012, at 1:42 AM, TMFAleph1 wrote:

    <<I keep telling you these companies yield over 10% because the market realizes that these yields can't be counted on.>>

    And I keep telling you that is plainly incorrect; please re-read the article.

  • Report this Comment On March 08, 2012, at 7:36 AM, BFatConservative wrote:

    @PoudMutt

    The reason for this is that Roth IRAs get preferential tax treatment (aka, you are not taxed) on any gains/dividends developed inside this vehicle. The reason for this is that you were taxed before you ever put your money into this vehicle. Nearly without exception, Dividends are taxed at an ideal low rate of 15%.

    So basically by owning an mREIT in Roth, which traditionally returns all of it's appreciation back to investors through dividends, you are not reaping the tax bliss that a dividend provides, because any investment increase inside of a Roth is not taxed to begin with.

    Disclosure: This is not tax advice. Exceptions exist.

  • Report this Comment On March 08, 2012, at 7:52 AM, marc5477 wrote:

    @poundmutt

    There are no strange tax problems with mREITs in an IRA but if you re-read the many articles about mREITs you will note that there are inherent long term risks with them. Basically if spread reduce to almost nothing, your yield will also be nothing and growth will be anemic (and price will reflect this reality). Look at NLY's history to see what I mean.

    In general, I do not advocate holding these guys more than a few years tops unless you got in at a steal of a price. Otherwise, if you plan to buy and hold to retirement, you will be better served long term with a stable REIT or any stable dividend blue chip like KO or MCD (not my favorites right now but you get the point). Over 20 years, these guys will probably return 4x the current yield and have 4x their current price. So in essence, if you plan to hold that long, those are better plays. Shorter term however, mREITs are fantastic but very volatile.

  • Report this Comment On March 08, 2012, at 8:02 AM, 2008Rehab wrote:

    I always thought mREIT stood for "more Really Eccentric Investment Theories" ...

  • Report this Comment On March 08, 2012, at 8:32 AM, rd80 wrote:

    @PoundMutt

    I don't know of any reason not to hold mREITs in an IRA account.

    mREIT (and I think all REIT) dividends are not qualified dividends since the company didn't pay taxes on the earnings and are taxed at ordinary income rates. So, from a tax standpoint, they're better off in an IRA than in a taxable account.

    I owned HTS - an mREIT - in both a Roth IRA and a taxable account and the dividends from the taxable account were treated as ordinary income and there were no issues with the Roth dividends.

    Sold HTS last fall because I was getting uncomfortable with the risks.

    This shouldn't be considered tax advice.

  • Report this Comment On March 08, 2012, at 9:44 AM, awallejr wrote:

    <And I keep telling you that is plainly incorrect; please re-read the article.>

    Nothing to re-read. You created the initial premise and then argued against it. Your article is general at best and completely shallow when discussing stock specifics like NLY.

  • Report this Comment On March 08, 2012, at 10:24 AM, compufixer wrote:

    My opinion, mREITS, like bonds & bond funds are highly appropriate for IRAs & Roths. All these income sources are taxed as ordinary income. On the other hand, stock & equity fund dividends & cap gains are taxable at a much lower rate. So they can be held in a non-IRA account.

  • Report this Comment On March 08, 2012, at 10:43 AM, TMFAleph1 wrote:

    <<You created the initial premise and then argued against it. >>

    I created it? Did you read the quote from the CAPS pitch that I included expressly to prove this was no straw man argument?

  • Report this Comment On March 08, 2012, at 11:29 AM, JustMee01 wrote:

    @TMFAleph

    "<<I keep telling you these companies yield over 10% because the market realizes that these yields can't be counted on.>>

    And I keep telling you that is plainly incorrect; please re-read the article."

    To be honest, I don't really see much in the article. You cite low barriers to entry (agreed), then state that they can't exceed market returns without bearing excess risk. The final 'reality' as you put it is just a statement that you don't have an axe to grind.

    There's just not much there to re-read, to be honest. I know you have a word limit, because of the average reader's ADD. But, the ROE/ROA issue would have been much better to pursue.

    You're probably onto something with regard to that issue. It's tough to explain the ROA without cracking the 10-K. Annaly apparently has a lot of 'other' income (expense) that makes results bounce, if Morningstar's data are correct. ROE maybe not be as hard to explain: their leverage is down to 6 to 1, versus 9 to 1 pre-crisis. If you had followed that up, it would have been interesting and more useful. As it is, the article seems to say there's "risk buried there somewhere" and that's about it.

    Instead of urging people to read 10-Ks, it might be more effective to highlight those risks and show them how to read one. Some people can't even find a 10-K, let alone read one.

    I hope this doesn't sound too negative. I just found the article pretty general, when you had an interesting point that you chose not to pursue. Pursuing it would have been a better choice IMO. I don't own NLY at the moment. Don't like the interest rate risk, when rates rise. That said, rates aren't likely to rise anytime soon if Ben B. is in control and unemployment continues to stay high.

  • Report this Comment On March 08, 2012, at 11:35 AM, mikecart1 wrote:

    Basically this article is saying don't put all your eggs in one basket. You can say the same about any company - including Mr. Untouchable Apple. No company is perfect. No sector is perfect. No set of investments is perfect. The key is patience and knowing when the buy and sell.

  • Report this Comment On March 08, 2012, at 12:14 PM, TMFAleph1 wrote:

    <<Basically this article is saying don't put all your eggs in one basket. You can say the same about any company - including Mr. Untouchable Apple.>>

    Mike--

    That's not the point of the article. I'm not saying investors shouldn't go "all in" on mREITs -- that's too trivial to merit an article. My point is that there appears to be a significant proportion of mREIT investors who don't understand the risks associated with the shares they own.

  • Report this Comment On March 08, 2012, at 12:20 PM, TMFAleph1 wrote:

    <<To be honest, I don't really see much in the article. You cite low barriers to entry (agreed), then state that they can't exceed market returns without bearing excess risk. There's just not much there to re-read, to be honest>>

    That is all you need to put paid to the erroneous notion that mREITs' outsized yields simply reflect the fact that investors don't believe the dividends are permanent.

  • Report this Comment On March 08, 2012, at 12:50 PM, JustMee01 wrote:

    @TMFAleph

    "That is all you need to put paid to the erroneous notion that mREITs' outsized yields simply reflect the fact that investors don't believe the dividends are permanent."

    I just don't see that as much of a point. There's risk present in high yield stocks?

    That's it? That seems to lack substance to me.

  • Report this Comment On March 08, 2012, at 2:04 PM, MKArch wrote:

    Alex,

    I skimmed through posts here and in the thread that awal linked and it seems to me your main issue with mREITS is that some sort of panic may cause their short term funding to dry up and this would render them insolvent.

    Didn't this exact scenario just happen to a lot of businesses just a couple of years ago wiping out entire business models like monoline sub-prime lending? One of my once favorite TMF H.G. rec's FMD's whole business model siezed up but the mREITS survived and thrived.

    If the financial panic a couple of years ago didn't wipe these companies out what would it take?

  • Report this Comment On March 08, 2012, at 2:07 PM, futbolgenius wrote:

    Alex,

    Plenty of, shall we say, misinformation at the worst. If I give you the benefit of the doubt, we'll just conclude that you're talking about something you don't quite understand. But that's OK! If we only stayed in our comfort zone, we'd never learn anything.

    To begin with your first point. This is a straw man argument, or equivocation at the least. I don't know if *anyone* mentioned REITs as free money, as you claim, since there was no citation. Rather, the comment that you cited deals with an inference about the government in relation to NLY: namely, that the past action of the gov't saving Freddie & Fannie means that, should NLY fail, the gov't will do the same. We could argue the merits of this statement. Personally, I don't agree; NLY lists the role of Freddie & Fannie, along with the US gov't, as a possible risk in their own 10-K (you *did* read that, right? The whole thing, not just the risk factors?). But that wasn't the bulk of your article.

    NLY makes money by borrowing at (currently ultra-low) short-term interest rates to purchase securities. They were levered at 5.4:1 at the end of CY 2011, below their target of 8-12:1 mainly (in my opinion) because of Operation Twist. By lowering the spread on the treasury yield curve, this hurts NLY in a material way. It's not just a function of ultra-low short-term rates; the spread is how they make money and pay dividends.

    Up until your article, I haven't heard one NLY/REIT shareholder claim any barriers to entry or that they had a moat. The only barrier I can think of would be the sheer mind-numbing quality of investor-speak a REIT has to fully understand. Why do you think Cramer only endorses NLY? It's not because he understands what the heck REITs do. Rather, it's because CEO Mike Farrell is the best in the business. Which might be NLY's only recognizable moat beyond their investing principles, but anyone can adopt those. It's sticking to them that counts.

    If you wanted to write an article highlighting the very real risks associated with REITs, you would have been better served sticking to the yield curve (not many people realize Op Twist had adverse effects on NLY; check out any REIT chart on 9/21/11, the announcement of the program, NLY dropped nearly 3% from 18.12 to 17.16 in one day, and all the way to around $15.50 by the first week of October). And you completely ignored the, again, *very real* return on NLY since its IPO in 1997, more than 500% if you DRIP'd since then. That's a track record I'm sure any equity would be happy to have.

    I realize the Fool may have word count rules, Alex, but that doesn't mean you can't choose the ones you have wisely. If you don't quite grasp what you're writing about, ask! I'm sure there are smart colleagues there at the Fool who can shed light onto this issue for you.

    Disclosure: Long NLY, even beyond 2014.

  • Report this Comment On March 08, 2012, at 2:38 PM, awallejr wrote:

    <I created it? Did you read the quote from the CAPS pitch that I included expressly to prove this was no straw man argument?>

    So you take some anonymous fool's quote and presume that is what people think? Of course you cherry picked it. Good God don't go reading the Yahoo Message boards your eyes will bleed over there.

  • Report this Comment On March 09, 2012, at 12:38 PM, fso001 wrote:

    NLY was just downgraded so it will be interesting to see what the underlying reason is.

    http://www.forbes.com/sites/marketnewsvideo/2012/03/06/analy...

    Any comments?

  • Report this Comment On March 09, 2012, at 10:29 PM, VettemanSF wrote:

    fso001,

    The downgrade was from "outperform" to "market perform", with a price target of $16-$17. Investors, especially the 50% that are institutions and mutual funds, are in NLY for the yield not short term price appreciation and that appears to be the underlying reason. Wells Fargo made a similar downgrade a few days ago.

  • Report this Comment On March 15, 2012, at 11:46 PM, bIlluminati wrote:

    The risk is interest rates (plus a small risk for pre-payments). If short-term rates go up, then their cost of funds goes up and their margin goes down. If long-term rates go up, then the net present value (NPV) of their portfolio goes down, although that doesn't affect cash flow unless NLY is forced to liquidate mortgages.

    So you want to watch the balance sheet closely. I'd say that right now this is an avoid, as I expect net income to be less going forward. I prefer companies with net income increasing at least 10% per year. I'm showing NLY EPS down 73% last four quarters.

    But if interest rates start dropping again, NLY share prices should rise along with their dividend.

  • Report this Comment On March 26, 2012, at 5:26 PM, TMFAleph1 wrote:

    In response to this article, I received the following from a professional investor and CFA charterholder:

    "Came across your excellent piece about mREITs dividends.

    I believe all investors should have a clear understanding of their investments. mREITs are exceedingly complex investments to analyze and unless shareholders are comfortable with such topics as prepayment risk/CPR, repo financing and duration, they should avoid the sector. Company updates are regularly peppered with such terms as interest rate spread, margin requirements, swaptions, undistributed taxable income, “comprehensive income,” and “economic return.” If a potential investor can’t make it past page three of the management presentation without diving for a bond analysis textbook, this may not be a good place for their money. I would highly recommend that any existing or potential investor review a management presentation from AGNC or NLY as an example.

    Unlike a firm that sells a well-understood product or service where the capital structure is only one part of the analysis; for an mREIT the capital structure is virtually the entire risk. While many mREITs invest in agency paper, this only reduces one aspect of risk. The returns are enhanced to by significant amounts of leverage so the yield curve can impart a dramatic (or devastating), impact on returns. The company’s hedging strategy-if employed-can reduce risk, but requires a great degree of sophistication. Additionally, while the implied government guarantee of Freddie and Fannie helps with one risk sector, other government programs enacted (HARP) or proposed will likely significantly impact mREITs. The political risk is not to be dismissed, nor is it easily evaluated.

    I have professional experience with REITs of all types as well as MBS and CMBS. I currently have positions in AGNC and NLY as I believe they have some of the better management teams and think they are an interesting short-term play, but feel those positions require virtually daily monitoring. These are not “undiscovered investments” as AGNC alone has a $6b market cap. Investors of all stripes have looked at these companies and determined that the risks justify the yield."

  • Report this Comment On June 22, 2012, at 5:35 PM, TMFAleph1 wrote:

    “It’s a double whammy and a little unsettling for the repo market to no longer have SOMA lending as a backstop,” said Michael Cloherty, head of US interest rate strategy at RBC Capital Markets.

    'Operation Twist' threat to bond trading, Financial Times, Jun. 21, 2012

    http://www.ft.com/intl/cms/s/0/a8e4fc4c-bba8-11e1-90e4-00144...

    "As a reminder, there has been abnormally low liquidity, reflected in offer-to-cover ratios, in the recent auctions for some of the Treasuries that the Fed purchases as part of the program. Other strategists have also pointed out that the Fed has a dwindling supply of sub-three-year Treasuries to sell, which among other things might exacerbate future strains in repo markets."

    RBC: Problems with extending Twist... not fixed by extending Twist, FT Alphaville, Jun. 22, 2012

    http://ftalphaville.ft.com/blog/2012/06/22/1056421/rbc-probl...

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(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: 1802486, ~/Articles/ArticleHandler.aspx, 11/28/2014 7:12:20 PM

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