Mortgage REITs Are Starting to Look Very Compelling

The mortgage REITs have been beaten up badly over the past six months or so, suffering as a result of the rapid rise in interest rates.

My view has been that long-term holders of these companies will be just fine, but there may be some downside in the short-term as interest rates start to rise. However, after further declines, I would like to revise my position and give some reasons to buy into the major mortgage REITs such as Annaly Capital Management (NYSE: NLY  ) right here and now.

Source: 401(k) 2013 on Flickr.

A bit about the recent price action
One of the main reasons the recent declines have been so drastic is that this rate spike was largely unexpected. The Fed has left rates unchanged for some time, so there was no reason to think 30-year mortgage rates would pop from the mid-3% range a year ago to about 4.5% today.

First reason to buy: Insider buying frenzy
As share prices have fallen, there's been a wave of insider buying within the major mortgage REITs. Annaly, for example, saw four major insider buys in November alone from four different officers ranging from 20,406 to 100,000 shares. 

Fellow mortgage REIT American Capital Agency  (NASDAQ: AGNC  ) also saw four executives purchase shares between October 30 and December 2 ranging from 2,000 to 25,000 shares (bear in mind that American Capital's share price is more than twice that of Annaly's). Smaller competitor American Capital Mortgage Investment (NASDAQ: MTGE  ) also has seen several insider buys recently. 

Second reason to buy: Good management
In Annaly's case, management has been very proactive in changing its game to adapt to the changing interest rate environment. The company has been decreasing its leverage by buying less fixed-rate agency mortgage-backed securities, which helps to lessen any further impacts of rising rates. It is also increasing its investments in commercial real estate, which rose 28% over the last quarter alone, now making up 11% of Annaly's investments. Commercial real estate is expected to grow by double-digit rates over the next two years, which, given the uncertain nature of interest rates right now, may prove to be a very wise move.

The others are making good moves, too. American Capital Agency is repurchasing its own shares, which is a no-brainer with shares trading below book value. It has also increased its purchase in fixed-rate (as opposed to floating-rate) short-term mortgage-backed securities. American Capital Mortgage recently acquired residential mortgage loan servicing company Residential Credit Solutions, which allows it to buy new types of investments, such as mortgage servicing rights, or MSRs, which the company could use as a hedge.

Best reason: Dividend-created price predictability
My favorite reason to buy the mortgage REITs is that their prices are completely predictable once you know their dividend yield. Each company tends to gravitate to a rather precise dividend yield, which is a product of the particular investments the company has, how much leverage is used, etc. When looking at the charts, it is uncanny how predictable this is.

Before we look at any price charts, consider that Annaly has paid quarterly dividends of $0.45 (December 2012 and March 2013), $0.40 (June 2013), and $0.35 (Sept. 2013) over the past year. Annaly's "number" seems to be a 12% annual yield. Using the quarterly dividends, a $0.45 dividend would mean a share price of $15 at a 12% yield, a $0.40 dividend implies a price of $13.33, and a $0.35 dividend corresponds to a share price of $11.67. The $0.30 dividend that Annaly just declared would mean a $10 price tag. Take a look at Annaly's chart from the past year and compare it to the above-predicted share prices and the time periods listed.

Source: TD Ameritrade.

A similar statement can be made for American Capital Agency, whose last four dividend payments were $1.25, $1.25, $1.05, and $0.80. Shares tend to gravitate to around a 15% dividend yield because of the company's higher use of leverage, so this yield would correspond to prices of $33.33, $28, and $21.33. The current share price seems to imply a dividend payment in the $0.70-0.75 range, however the company has declared a lower $0.65 payment for this quarter, perhaps indicating that the market believes the low payment to be temporary.

When to buy?
I am very confident in advocating all of these companies at their current price levels, with a personal preference of Annaly because of its management and its less aggressive use of leverage. However, all of these have the potential to shoot up immediately if the upcoming dividends are higher than expected. At the moment, use $10 as a guide for Annaly and $20 as a guide for American Capital Agency. I believe both stocks are a steal under those prices, especially now that rates should become a little more predictable as a result of the Fed's taper.

Even more dividends
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