Given the low yields provided by fixed-income instruments, high-yielding mortgage REITs may offer an attractive opportunity for investors.
What are mortgage REITs?
Mortgage REITs invest in mortgage-backed securities (MBSes) using short-term financing. Since their investments are long term in nature, they yield interest farther out on the yield curve. The cost of financing these investments is lower because the borrowing is short term.
As a result, mortgage REITs earn a spread between the interest received (on assets) and interest paid (on financing). By law, at least 90% of the income earned by an mREIT has to be shared with its investors. To offset this high payout, mortgage REITs are taxed at a preferred rate.
Opportunity in difference
Two Harbors (NYSE:TWO), PennyMac Mortgage (NYSE:PMT), and Newcastle Investment (NYSE:NCT) are mREITs that follow a different strategy than the largely followed mREITs like Annaly Capital Management and American Capital Agency, and this is why they may offer great opportunities.
The odd one out
According to a recent research note published by analysts at Credit Suisse, Two Harbors is one of the rare mortgage REITs that could report an increase in book value if the rates continue their upwards journey. Analysts estimate a moderate increase in the company's book value at the end of the current quarter, as opposed to sectorwide book value declines.
The reason for this is the structure of its investment portfolio. According to its latest quarterly disclosures, Two Harbors has an investment portfolio that is well diversified with an ideal mix of MBSes backed by government guarantees (agency MBSes) and MBSes that are not backed with any such guarantees (non-agency MBSes.)
The company is also making progress toward further diversifying its portfolio through the addition of mortgage servicing rights (MSRs.) These are rights to service a mortgage that are sold by the loan originator to specialized companies.
Distressed loans reap profits
Like Two Harbors, PennyMac Mortgage Investment Trust also has a diverse asset base that primarily includes residential mortgage loans. PennyMac Mortgage also happens to be one of the few mortgage REITs that recently reported an increase in its book value, when most of its peers were losing book value. The company's second-quarter performance remained better than expected, mostly because of a gain on sale margins.
Going forward, analysts at Credit Suisse expect a nearly 1% increase in PennyMac's book value. The company sees an opportunity in distressed mortgage loan acquisitions and acquisition of bulk MSRs. PennyMac Mortgage's MSRs deliver more return under rising interest rates. When rates go up, refinancing slows down -- this extends the average life of an MSR, making it more valuable for the company.
The company also expects to get some support from further gains on its distressed loans portfolio. In an improving housing market, PennyMac's distressed loans can be refinanced near or at face value. Remember, these are purchased by PennyMac at huge discounts of as much as 50%. When the loan gets paid off near 100%, PennyMac's profits grow significantly.
Newcastle Investment operates as a mortgage REIT with major investments in real estate loans, MSRs, and other real estate related assets. The company also has exposure to senior housing through its recent spin-off. As a result, Newcastle has exposure to both the U.S. real estate market and the senior housing market.
The senior housing market presents investors with an attractive opportunity as demographics reveal that the population of those age 65 and older has been on the rise and will continue to increase in the future. Given this backdrop, the senior housing market in the U.S. is characterized by an attractive supply demand imbalance. The rapidly growing aging population will drive the demand for more senior care facilities in the future. The supply has not kept pace with this increased demand, however.
As such, the company aims to take advantage of this imbalance and build a strong portfolio of such properties.
Given the uncertainty in interest rates, it is important to consider the various headwinds and tailwinds impacting these various mortgage REITs.
James Clarkson 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.