While real estate investment trusts (REITs) have suffered over the past year as interest rates have risen, investors are beginning to take a closer look at the mortgage REIT space. These stocks have pretty big dividend yields, and can make enticing prospects for a dividend investor's portfolio.
That said, mortgage REITs are different than most REITs and it pays to understand how they work. One of the biggest mortgage REITs is AGNC Investment (AGNC 0.97%). Is the stock a buy?
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Mortgage REITs have a different business model
Mortgage REITs are different than the typical REIT. Most REITs develop properties and then rent them out. Their profit margin is based on rent minus interest expense, which is an easy-to-understand business model. Mortgage REITs don't invest in properties, they invest in property debt -- in other words, mortgages. Instead of collecting rent, they collect interest. Their business model looks more like a bank or hedge fund.
AGNC is a mortgage REIT that invests almost entirely in mortgage-backed securities that are guaranteed by the U.S. government. If you recently bought a house with a Fannie Mae or Freddie Mac mortgage, chances are it was securitized and it might have ended up in a mortgage-backed security (MBS) held by a company like AGNC Investment. A government-guaranteed mortgage means that if the borrower fails to make a monthly payment, the government agency backing the mortgage ensures the MBS investor still gets paid. While mortgage-backed securities therefore have minimal credit risk, they have a lot of interest rate risk.
Interest rate volatility has hurt the mortgage REIT sector
Over the past 18 months, mortgage-backed securities have underperformed Treasuries. This is because bond market volatility has increased due to the Fed's tightening policy. Most mortgage REITs have been forced to cut their dividends over the past year, but AGNC has been one of the few that hasn't had to cut its monthly dividend. AGNC has seen consistent declines in book value per share, and the stock has struggled.
It all depends on the Fed
Going forward, mortgage REIT investors will be at the mercy of the Federal Reserve. The end of the tightening cycle will go a long way toward reducing volatility in the bond market. The difference between the yield on mortgage backed-securities and Treasuries is extremely high, and AGNC Investment expects that its portfolio will deliver mid-teens returns going forward, even if this underperformance isn't reversed.
Since AGNC Investment already has a 14% dividend yield, it will need this type of return going forward to support the dividend. Investors buying AGNC Investment at these levels are betting that the underperformance is about over, and mortgage-backed securities will revert to historical levels versus Treasuries.
Of all the mortgage REITs out there, AGNC is probably the easiest to understand. It takes almost no credit risk, and is all about managing interest rate risk. Even government-guaranteed mortgage-backed securities can lose money, as Silicon Valley Bank found out the hard way.
AGNC's tangible book value per share came in at $9.41 at the end of the first quarter, and it is generally a good idea to buy mortgage REITs when you can get them at book value or lower. The dividend yield of 14% is attractive as well. The best idea is probably to wait until the Federal Reserve is done hiking interest rates. Once the Fed has completed its tightening cycle, interest rate volatility should fall, which will be a much more supportive environment for mortgage REITs like AGNC.
