However, it's important to understand how to analyze mortgage REITs, which really operate like levered bond funds. Knowing how a given fund's portfolio will be affected by changing interest rate environments and what hedging strategies the fund managers are using is essential.
Aside from REIT requirements - 75% of all assets must be real estate-related and 90% of taxable income must be returned to investors as dividends - mortgage REITs have little in common with more familiar property REITs. Agency mortgage REITs, which include names like Annaly (NLY) and Anworth (ANH) or more recently American Capital Agency (AGNC) and CYS Investments (CYS) - fulfill the real estate requirement by owning mortgage loans or bonds guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae rather than real property, and finance those purchases at low short-term rates.
OWNING A BANK (MINUS ATMS)
This makes owning shares in a mortgage REIT akin to owning a bank, minus the branches or ATMs. And the similarity to the banking business model, it turns out, is the main reason mortgage REITs are so popular now.
Even after funding costs and hedging, competent mortgage REIT managers can lock in spreads of 200 basis points or so. With modest leverage around 8-to-1, they can achieve return on equity in the mid-teens (and by definition have to distribute 90% of the taxable income back to investors as dividends).
The Fed has said it intends to keep the cost of financing mortgage securities near zero until well into 2013. This makes the mortgage REIT business model fundamentally more attractive than it was during its last wave of popularity in 2004 and 2005.
If 8-to-1 leverage sounds high, consider this: When a bank holds a mortgage that is not guaranteed by Fannie Mae or Freddie Mac, that bank is required to hold 8% capital in reserve (11.5-to-1 leverage). For bank holdings of Fannie or Freddie guaranteed mortgage-backed securities, that credit reserve requirement is cut by 80% to just 1.6% capital (more than 60-to-1 leverage). Banks do hold additional reserves for interest rate risk, but mortgage REIT leverage still looks tame by comparison.
Leverage magnifies both returns and risks, of course. So a careful review of how each agency mortgage REIT manager has built a portfolio can help investors see a difference in risk profile that the markets may not fully recognize.
Consider two seemingly very similar and hypothetical $100 million mortgage REITs, both of which have levered themselves 8-to-1 and both of which have bought exclusive agency-guaranteed mortgage-backed securities. Let's call them FixREIT (it buys all fixed-rate mortgage-backed securities) and ArmREIT (which buys only pools of bonds made from adjustable-rate mortgages). For comparison, assume each REIT holds $900 million of mortgage pass-throughs, and that each has fixed costs of $1 million per year.
Neither of these hypothetical REITs matches portfolios currently in the market, but this analysis can help planners sift through publicly available information to determine which mortgage REITs, if any, might be appropriate for clients. At 14% yield for FixREIT, compared with a 10% yield for ArmREIT, most investors gravitate toward the higher yield. But what happens when interest rates go up just two percentage points?
As with any bonds, mortgage-backed securities lose value when interest rates rise. With leverage, the effect of price loss on the shareholders will be multiplied by the leverage.
PREPAYMENT PROBLEM
Before looking at the comparison chart (below), consider the essential "problem" with residential mortgages: the prepayment option. When an investor buys a new 30-year fixed-rate mortgage, that mortgage contains an option for the borrower to pay off the mortgage early, usually without penalty, any month before maturity. The potential for increased early prepayment due to government efforts to help borrowers refinance is a main reason mortgage REIT stocks have suffered price declines over the past few months, analysts say.
This is one risk, to be sure. But mortgage REIT investors should actually be worried about the prospect of a rise in interest rates and resulting slower prepayments since that is the bigger risk to their capital and income.
For example, the 4.5% FNMA pass-through used as FixREIT's theoretical portfolio is priced as though 30% of the borrowers will pay off their mortgages every year starting in 2012. If mortgage rates rise to 6.5% by then (still historically low), investors might expect only 8% to 10% of those borrowers to pay off their mortgages each year, and that 2.75-year bond that FixREIT owns might look more like a seven- to nine-year bond. ArmREIT will fare better, since its borrowers were scheduled to shift to adjustable mortgages three years from now, with little incentive to prepay (or not) at that point, no matter where rates go.
