Which 6 mREITs Can You Profit From?

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Annaly Capital Management (NYSE: NLY), a pioneer mortgage REIT, is looking to diversify its business by offering $840 million for the remaining 88% of CreXus Investment (NYSE: CXS.DL). This bid is being made after the Federal Reserve declared relentless bond buying. The latest round of quantitative easing initiated by Fed, dubbed "QE Infinity," aims to mop up $40 billion of agency mortgage backed securities (MBS) every month and in doing so is squeezing Annaly's interest rate spreads.

The lack of high-yield investment is starting to hit levered mortgage REITs. Which of these REITs, if any, are appropriate for investing?

Irresistible Dividends

Income investors are attracted to these levered mortgage REITs because of their high dividend payouts:

<table> <tbody> <tr> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>D/E</strong></p> </td> <td> <p><strong>Yield</strong></p> </td> <td> <p><strong>Payout Ratio</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>P/B</strong></p> </td> </tr> <tr> <td> <p>AGNC</p> </td> <td> <p>American Capital Agency</p> </td> <td> <p>7.26</p> </td> <td> <p>15.9%</p> </td> <td> <p>2.11</p> </td> <td> <p>10.45</p> </td> <td> <p>0.96</p> </td> </tr> <tr> <td> <p>ARR</p> </td> <td> <p>ARMOUR Residential</p> </td> <td> <p>8.12</p> </td> <td> <p>15.4%</p> </td> <td> <p>1.66</p> </td> <td> <p>7.69</p> </td> <td> <p>0.89</p> </td> </tr> <tr> <td> <p>CIM</p> </td> <td> <p>Chimera</p> </td> <td> <p>1.85</p> </td> <td> <p>13.1%</p> </td> <td> <p>1.11</p> </td> <td> <p>5.27</p> </td> <td> <p>0.84</p> </td> </tr> <tr> <td> <p>HTS</p> </td> <td> <p>Hatteras Financial</p> </td> <td> <p>7.43</p> </td> <td> <p>12.0%</p> </td> <td> <p>0.98</p> </td> <td> <p>7.49</p> </td> <td> <p>0.82</p> </td> </tr> <tr> <td> <p>NLY</p> </td> <td> <p>Annaly Capital Management</p> </td> <td> <p>6.04</p> </td> <td> <p>13.6%</p> </td> <td> <p>1.45</p> </td> <td> <p>10.22</p> </td> <td> <p>0.84</p> </td> </tr> <tr> <td> <p>CXS</p> </td> <td> <p>Crexus</p> </td> <td> <p>2.11</p> </td> <td> <p>10.3%</p> </td> <td> <p>1.02</p> </td> <td> <p>10.50</p> </td> <td> <p>1.05</p> </td> </tr> </tbody> </table>

In today's low interest rate environment high dividend yields like these are hard for fixed income investors to resist. Sadly each of the firms on this list has an unsustainable dividend payout.

Worse yet, there are problems specific to leveraged mortgage REITs beyond paying unsustainable dividends.

How mREITs Work

These REITs create highly-leveraged positions in mortgage notes. These entities buy mortgage loans and then use those loans as collateral to buy more mortgages, and then repeat this borrowing and buying process multiple times. All in all, these trusts use margin borrowing purchase multiple times their assets in mortgage loans.

These positions are attractive today since mortgage yields are higher than short-term interest rates. REITs exploit the spread between borrowing short and lending long on long term mortgage rates. Their leverage allows them to reap multiple times the spread.

What if the spread narrows? The difference between mortgage rates and short-term borrowing costs could become smaller and smaller, destroying business opportunity exploited by levered mortgage REITs.

There are other industry-specific risks. An endless parade of political meddling in mortgage lending could drop the value of mortgages or alternatively make them too expensive. If the prices drop low enough a leveraged mortgage REIT could become insolvent. If they raise too high, yields will be too low for the business to continue.

Each levered mortgage REIT has firm-specific risks. Portfolio managers could make a number of bad investments which fail to provide expected income or plummet in resale value. The loss of income would drop dividend payouts, and income investors might angrily sell their shares causing the price of the REIT to plummet. Harsh write-downs in REIT portfolios could trigger loan covenants with their lenders. Portfolio losses could result in illiquidity, insolvency, and ultimately default. Borrowing short and lending long is a risky strategy for the long run, as the history of hundreds of bank failures since 2008 makes abundantly clear.

Many dabble in extensive leverage, as is captured in high debt-to-equity ratios.

Spreads Narrowing

Mortgage REITs which have delivered high dividend income thus far are at a crossroads. Their borrowing costs have been near zero have been suffering reduced incomes and dividends since the Fed's most recent quantitative easing announcement. This has prompted investors to flee these REITs for alternative securities. In a phone interview, Annaly's Co-CEO Wellington Denahan-Norris said, "It's not just at the mortgage REITs where the returns in this market are being put under assault."

If the cost of borrowing increases, then levered mortgage REITs may be forced to review their debt-heavy capital structures since the use of more debt may result to greater decline in dividends and net incomes. There could be a temptation to take on riskier, higher-yield securities to maintain spreads. Two Harbors Investment (NYSE: TWO) co-CIO Bill Roth has warned investors that this is not the right path. "We're not in a game where we're going to jack up leverage or change our risk profile to manufacture some return," he said in a telephone interview. Unfortunately he does not speak for the entire industry, and many REITs however might choose to be less conservative.

Consolidation

Mortgage REITs which can't find mortgages at attractive yields in the secondary market could liquidate or seek grow by acquiring other mortgage REITs. Real estate giants Annaly Capital Management intends to acquire CreXus Investment for around $839 million. A statement from Annaly confirms the company is interested in buying extra shares at a price of $12.5 per share which was a premium of 13% to its closing of $11.1 on November 12th.

Annaly currently holds 12% share in CreXus, a little over 9 million shares of its 77 million outstanding shares. CreXus shares rose 12.6% in pre-market trade based on this takeover interest.

Annaly Chairman and CEO Wellington Denahan said in a statement that the buyout proposal would "provide an opportunity to diversify part of its investment portfolio.

Currently CreXus is managed by Fixed Income Discount Advisory which is a subsidiary of Annaly. Annaly hopes that CreXus management would create a special committee to consider the offer made by Annaly.

With the decision to buy the rest of CreXus, Annaly acknowledges that it needs other lines of business for attractive risk-adjusted returns. Annaly's business model is simple: it borrows short term at low rates and buys higher yielding MBS guaranteed by Fannie Mae or Freddie Mac and profits on the interest differential. While MBS comprise about 90% of Annaly's portfolio, CreXus invests mainly in commercial MBS and commercial mortgage loans.

With its cash hoard of $2.26 billion and plans to diversify further, some analysts are guessing that Chimera Investment (NYSE: CIM) could be Annaly's next target. Annaly already owns 4.4% of Chimera and the latter is also being externally managed by Annaly's Fixed Income Discount Advisory unit. Annaly, with a current market value of about $14.4 billion can easily acquire Chimera which has a market value of around $2.7 billion. Chimera still needs to straighten out certain accounting issues and sort out through the toxic assets it was left holding when "the music stopped" during the sub-prime boom.

Conclusion

Investors should be choosy when picking leveraged mortgage REITs. They avoid should Annaly's buying spree and avoid CreXus since it has been bid up. Instead, investors should consider Chimera and Hatteras (HTS). Chimera has a shot of being acquired by Annaly, and Hatteras trades at the lowest P/B ratio among its peers.

I should also note if you are comfortable with a small holding of either mortgage REIT, they should reside in a tax-advantaged account like an IRA. There are special tax implications awaiting investors who receive the REIT dividends. Their distributions are not taxed differently than long-term dividend income from stocks. Instead, they are taxed as regular interest. Hence they are less appropriate outside of a tax-advantaged account.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Annaly Capital Management. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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