Warren Buffett is famous for advising investors to "be greedy when others are fearful." This advice is apropos for the current mortgage Real Estate Investment Trust (mREIT) industry. The recent discussions of tapering by the Fed have struck fear in the mREIT market, causing this asset class to be beaten to a pulp. These low prices have created a unique opportunity to buy these stocks at rock-bottom prices and enjoy high income while waiting for the sector to recover.
What is an mREIT?
Mortgage REITs are a type of real estate company that invests in real estate mortgages. There are two types of mREITs;
- Agency mREITs invest in mortgages that are backed by government-sponsored enterprises (GSEs) such as Freddie Mac, Fannie Mae, and Ginnie Mae. These mortgages do not have credit risks, but generally do not pay as much interest.
- Hybrid mREITs invest in both agency and non-agency mortgages. The non-agency mortgages are not guaranteed by the government, which results in higher interest payments.
Mortgage REITs provide funding to perspective real estate buyers by investing in mortgage-backed securities (MBS). Since long-term real estate mortgages usually have higher interest rates than short-term loans, the mREIT companies can borrow money to fund their MBS purchases. By using the mortgages as collateral, the mREIT can borrow even more money. This cascading effect of borrowing is called leverage, and mREITs typically borrow 6 to 10 times the amount of their original funding.
When the interest rate environment is favorable, leverage leads to outsized profits. In addition, the tax code requires REITs to pass 90% of their taxable income to investors each year. Thus, mREITs have been an excellent source of income and are known for delivering breathtaking yields.
Key to profitability
The key to mREIT profitability is the difference between the mortgage interest rate and the short-term interest rate. This difference is called the "spread," and the larger the spread, the more money mREITs make.
Recently, the spread between the 10-year Treasury and 30-year Treasury has narrowed and put pressure on mREITs. In addition, the Fed, who are purchasing $40 billion of mortgage-backed securities each month, hinted that they would begin to reduce purchases. This was a perfect storm that caused a bloodbath in the mREIT sector.
However, long-term investors should realize that many mortgage REITs survived the wave of refinances in 2003, the rising interest rates in 2004, and the market meltdown in 2008. There is no reason to think they won't be able to survive the tapering storm and provide excellent income over the long term.
Two Harbors Investment (NYSE:TWO) is a hybrid mREIT that has assembled a diversified portfolio of investments that will enable it to better navigate these turbulent times. It holds about 80% in agency residential mortgage-backed securities with the rest in non-agency mortgages. It has also moved into the prime jumbo mortgage market and is building its own origination network.
Since its inception in 2009, Two Harbors has delivered a total return of 137% (through March 2013). With $2.51 cash per share, it has the resources to deliver an annual dividend of $1.24 per share, which equates to a yield of 12.9%. At a price-to-earnings of only 4.3 and a price-to-book of 0.92, Two Harbors could be an excellent value play.
American Capital Agency (NASDAQ:AGNC) is an agency mREIT that distributes $4.20 per share per year back to investors, which is an outstanding 18.5% yield based the current dividend. To maintain this high yield and insulate itself from increases in interest rate, it has moved 42% of its portfolio into 15-year mortgages (which are less sensitive than 30-year mortgages to increases in interest rates).
Even with wild gyrations of interest rates during the second quarter, American Capital Agency was able to maintain its interest rate spread. Again, with $7.37 in cash, the $4.20 annual dividend appears to be affordable. At a price-to-book ratio of 0.85, this stock offers high income at bargain basement prices.
Largest Mortgage REIT
Annaly Capital Management (NYSE:NLY) was founded in 1997 and is the largest mortgage REIT, with a market cap of over $11 billion and income of $3.37 billion. Over the years, Annaly Capital has generated compelling returns to investors, distributing over $9 billion in dividends to shareholders.
Previously, Annaly Capital invested in only fixed rate agency mortgages but has recently diversified its portfolio by purchasing CreXus, which is a commercial MBS company. Another plus is insider buying, as evidenced by one of the directors, John Schaefer, recently buying 25,000 shares.
Annaly is not quite as cheap as some of the other selections, but it has an excellent long-term track record. It still sells at a 15% discount to book value. The dividend is an impressive $1.68 per share, which is a yield of 13.6%. Now could be the time to buy Annaly Capital while it is still a bargain compared to historical valuations.
Foolish bottom line
Mortgage REITs are a volatile but potentially lucrative sector. Despite taking a dip recently, over the past five years, mREITs have been great income providers. The current downturn may provide an excellent buying opportunity. If you can tolerate the ups and downs, these companies will almost surely reward the patient investor.
John Dowdee 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.