Mortgage REITs run on a different type of business model compared to the property owning REITs that buy and hold commercial buildings to earn rents as revenue. The most common model for a mortgage REIT is to own a large portfolio of agency guaranteed mortgage backed securities – MBS – financed with borrowed money to generate an interest rate spread between the yield on the MBS and the cost of the funds borrowed to purchase the mortgage bonds.
To generate 11% to 12% dividend yields from mortgage securities that yield 3.5%, a mortgage REIT will borrow 6 to 8 times the company’s equity to leverage that equity into a larger portfolio of mortgage bonds. The result is a portfolio of bonds that yield say 3.5%, which cost 2% to carry, producing a 1.5% net yield. Multiply 1.5% times 7 produces a 10.5% yield. The equity portion of the portfolio earns the full 3.5%, giving a final net yield on the mortgage REIT’s holdings of 15%. Take out a couple of percent for management fees and another point to cover business costs and you get to your 12% yield on the book value per share of the REIT.
In a steady interest rate scenario, a mortgage REIT produces a much higher yield from government guaranteed mortgage backed bonds than almost any other income investment you can find. Falling interest rates are generally good for this type of company, since the yield on bonds already owned is locked in, borrowing costs will fall to increase the spread, and bond prices will rise, giving the opportunity to earn capital gains on the portfolio. This last case is the environment mortgage rates functioned in from the time mortgage rates dropped to record lows due to the 2007-2008 financial crisis until mortgage rates started to rise in early 2013.
The Risks a Mortgage REIT Faces
The business model of a mortgage REIT (mREIT) faces serious challenges if interest rates move in the wrong direction – Up. These companies are negatively affected by higher rates on both the short and long ends of the yield curve.
Rising short-term rates affect the mREIT’s borrowing cost, squeezing the spread earned on the portfolio. Consider that a 0.5 percent cost increase on a 7 times leveraged MBS portfolio reduces the yield by 3.5%. Short rate changes can be hedged to a great extent by a mortgage REIT, but those hedging activities also have costs, which eat into the spread earned by the company.
You might think that rising long-term rates would be good for a mortgage REIT, since the higher rates will be reflected in the yields on new mortgages. While this is true, mortgage securities already owned react to higher rates with falling bond prices. Falling MBS prices mean that the leverage on the mREIT’s portfolio will increase, causing the lenders on the borrowed money to ask for more collateral, reducing the leverage available. As bond prices continue to fall, the REIT will be forced to sell MBS at a loss, leaving less money to reinvest into new securities. Also, since much of the portfolio is leveraged, selling bonds just produces cash to pay off the borrowed money and leaves little in the way of equity capital to reinvest in now higher yielding mortgage securities. It is not possible for a mortgage REIT to effectively hedge against rising mortgage rates and falling MBS prices.
2013 was Crushing for mREIT investors
When mortgage interest rates climbed by about 1% in the first half of 2013 – to around 4.5% from 3.5% – the share values of mREITs fell off the cliff. From mid-March of last year through the end of the year, the share prices of the two largest mortgage REITs, Annaly Capital Management (NLY) and American Capital Agency (AGNC) dropped by 36% and 41%, respectively. These declines were not just a market sell-off, but were the result of actual declines in the companies’ book value per share. Again, the math tells the tale. For a bond portfolio leveraged up to 7 times the equity in the company, a 5% drop in bond values results in a 35% decline in the book value.
For several years before mortgage rates started to increase, the mREIT management teams were confident that their hedging strategies would protect investors against losses. However, as discussed above, hedging only works for the borrowing side of the mREIT model. There is nothing that can cost-effectively help against rising mortgage rates and falling MBS prices. After digging into the structure of these companies in late 2011 and into 2012, I started to warn investors that the inevitable shift to higher mortgage rates would be very damaging to share owners. There were plenty of warning signs back in 2011 and 2012, but it can be hard for an investor to see beyond an 11% or 12% dividend yield.
Will the 2014 Rally Last?
The first quarter of 2014 has been much better for mortgage REIT share prices. NLY is up 14% and AGNC has gained 17% on the year. Both yield around 11%. However, the current yield is based on dividends that are one-third lower than a year ago. The price gains have been good news for suffering mREIT investors, but the question is whether the gains can continue or even have the share prices stabilize so investors can count on a double-digit yield going forward.
My opinion is that the recent gains for mortgage REITs are more of a hope for better times than a sign that there has truly been a turn for the better for long-term investors. First, if you believe as I do that long-term interest rates and mortgage rates will continue to trend higher, there is not much these companies can do to keep both high dividends and maintain book value per share. Leverage can be reduced to protect a mREIT’s equity, but that move reduces the interest spread earnings and will force additional dividend reductions.
To truly find the bottom for your favorite mortgage REIT, keep a tab on the book value per share reported with every quarterly earnings report. I am looking for two to three consecutive quarters of an increasing book value combined with stable mortgage rates before I will again start to view the agency MBS owning mortgage REITs as potentially viable high yield investment choices.
What’s been your experience with mortgage REITs? Did you get caught short with last year’s interest rate rise? Are you still holding any or on the look-out to add some to your portfolio? Write me at [email protected].