Are Mortgage REITs Oversold?

With the stock market down 9% the past three months and the Federal Reserve trying to lower long-term rates, mortgage REITs have taken a beating. The iShares FTSE NAREIT Mortgage Plus Capped Index Fund (NYSE: REM) is down more than 13%, even including a hefty dividend payment. That said, investors are unfairly punishing mortgage REITs. Read on to see why I think they are oversold.

Investors have soured on mortgage REITs for three main reasons. One, with the markets gyrating, people are worried about anything they deem risky. Understandably, mortgage REITs that focus on risky assets such as Chimera Investment (NYSE: CIM) have underperformed the most.

Secondly, investors are worried about anything with large amounts of debt. Mortgage REITs use short-term repurchase agreements, or repos, to leverage their purchases of low-yielding mortgage securities. For example, American Capital Agency (Nasdaq: AGNC), which is run by a subsidiary of American Capital (Nasdaq: ACAS), invests in government-backed mortgage securities and leverages its assets by 7.6 times to boost its returns. Chimera, which invests in riskier, non-government-backed mortgages, uses just 1.9 times leverage. The government-backed mortgages that mortgage REITS use as collateral are deemed very safe by lenders. Even in 2008 when the credit markets were failing, the repo markets continued to work.

Third, people are worried about the effect of the Fed's plan to bring down long-term interest rates. If the Fed's plan works, homeowners may refinance their mortgages. This would be a problem for mortgage REITs, which bought mortgages at a premium to their face value. If homeowners refinance early, the mortgage REIT would only get back par on their investment.

None of these reasons are that strong. It would be far worse for mortgage REITs if the Fed raised short-term rates. However the Fed has said it will not raise rates for at least two years, and if slow economic growth and deleveraging continue, interest rates are likely to remain low. As equity prices are no longer debt-fueled, generating income from investments is important.

There are now some high-quality REITs priced at or below book value to help you do just that:

Source: Yahoo! Finance.

I own shares of Annaly in my high-yield dividend portfolio. I believe it and other mortgage REITs will continue to do well as the Fed keeps interest rates at very low levels for the next few years.

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