Avoid Mortgage REITs During QE3

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The third round of quantitative easing through which the Federal Reserve will purchase agency mortgage-backed securities, although considered a stimulus for the slowing economy, will have a negative impact on certain Real Estate Investment Trusts (REITs). REITs that invest exclusively in agency mortgage- backed securities (MBS) will be the ones that take the worst hit.

However, before we proceed, we should know a little more about REITs.

REITs make direct investments in real estate either through properties or mortgages. An REIT may be an equity, a mortgage, or a hybrid REIT. An equity REIT invests in owned property, whereas a mortgage REIT is an investor and owner of property mortgages. Hybrid REITs are a combination of both.

Mortgage REITs may hold agency mortgage backed securities or non-agency mortgage-backed securities.

REITs enjoy a unique tax status, which translates into better yield for investors, which is one of the major reasons of the popularity of REITs and REIT ETFs with the investor community. For example, top REITs such as Annaly Capital (NYSE: NLY) and American Capital (NASDAQ: AGNC) have dividend yields of 13.83% and 16.90%. The current average dividend yield of REITs is around 13%, which is almost seven times that of the average dividend yield of the S&P 500 Index.

Mortgage REITs

Asset portfolio of mortgage REITs comprises of mortgage-backed securities. Their income comes from the difference between what they earn from these assets and the interest they pay on their liabilities.

The Federal Reserve has been striving to bring down long-term interest rates through quantitative easing measures. Since mortgage REITs rely on interest rate spreads for their income, this has had a direct impact on their earnings potential. Already, some of the top mortgage REITs have been reducing dividend payouts. From $0.60 in the third quarter last year, NLY’s dividend payout has decreased to $0.50 in the quarter ending September 30. The trust has yet to officially announce its next payout. American Capital’s dividend payout declined from $1.40 to $1.25 per share in the same period.

In the third round of quantitative easing the Federal Reserve plans to purchase $40 billion in mortgage-backed securities a month. This has forced analysts to review the outlook for mortgage REITs in general.

The Federal Reserve will be purchasing agency mortgage-backed securities that have a fixed rate. Increase in demand for mortgage-backed securities, a direct result of the Federal Reserve plan of purchasing these securities, will increase their price. This, in turn, will translate into lower yield for the holder of MBS. The obvious shrinking interest spreads will have a negative impact on earnings of mortgage REITs. REITs with securities that are adjustable in nature or floating rate securities will not be hit as much.

Moreover, quantitative easing round three (QE3) will result in further easing of interest rates, which will act as an encouragement for those with high-interest mortgages to go in for refinancing. Increased prepayment on mortgages will hurt agency REITs as the expense on amortization increases due to prepayments. In addition, agency mortgage REITs purchased these securities at a premium. In contrast, non-agency MBS are acquired at a discount, which will actually benefit non-agency REITs. 

Signs of this are already visible in the stock prices of some of the major agency and non-agency REITs as shown in the chart (and discussed) below:

<img src="/media/images/user_14377/nly_large.png" />

Source: www.google.com/finance (download date November 13, 2012)

American Capital Agency

AGNC derives its income primarily from its leverage-based investments in agency mortgage-backed securities. These are the same that the Federal Reserve intends to buy. EPS of the REIT has declined constantly over the last three quarters – from $1.42 in fourth quarter 2011 to $0.79 in third quarter 2012. Initiatives taken by the Federal Reserve for bringing down long-term interest rates have resulted in decline of 23 basis points in the REIT’s net margin in the quarter ending September 2012.

Annaly Capital Management, Inc.

Like AGNC, Annaly also invests exclusively in agency mortgage-backed securities. The reported reduction in interest income of the company in the third quarter is to the tune of 14% while the net margin fell by 100 basis points to 1.2%

Invesco Mortgage Capital (NYSE: IVR)

The non-agency MBS component of IVR at the end of third quarter stood at 14.7% of its total assets, which resulted in a slight increase of $0.5 million in total income. However, the company also experienced a fall in interest spread, which fell by 24 basis points and the prepayment rate increased by 1%. IVR has a market cap of $2.18 billion and EPS of $2.75. Along with a dividend yield of 13.87%, the YTD return to Invesco Mortgage investors is 33.45%. IVR is slightly undervalued at 1.2 times book value and going forward can provide goods returns if it sticks to its hybrid strategy of investing in both agency and non-agency MBS.

Newcastle Investment (NYSE: NCT)

NCT is a real estate investment and finance company that has a portfolio of original home loans and non-agency MBS. The 9% non-agency MBS component was purchased by the company at 35% discount to par. It has a market cap of $1.28 billion and an EPS of $2.71. NCT’s YTD return is an astounding 59.57% and a dividend yield of 11.86%. The third quarter EPS of Newcastle Investment Corp. was $1.63, much more impressive than $0.35 reported in the corresponding quarter a year back. The stock is currently trading at a discount of 15.68% to its 52-week high of $8.80.

PennyMac Mortgage Investment Trust (NYSE: PMT)  

This is a specialty finance company that invests in residential mortgages and distressed non-agency MBS and mortgage related assets. The company reported an increase of 54% in turnover during the third quarter and an EPS of $0.81 per share as compared to $0.79 per share in the second quarter. It is a relatively smaller REIT with a market cap of $946.26 million. The company has a dividend yield of 10% and has hiked its dividend by $0.2 in the third quarter 2012.

Bottom Line

In our opinion, investors will do well to avoid mortgage REITs for the time being. Instead, industrial REITs such as Duke Realty and SL Green and some of the healthcare REITs such as Healthcare Trust of America and Omega Healthcare Investors not only provide a reasonable dividend yield but also have a fair potential for growth in the difficult times ahead.

Dig Deeper

Annaly Capital Management has a history of paying huge dividends to shareholders, made possible by borrowing at cheap short term rates and investing in longer term mortgage securities. But there are some things investors absolutely must know about Annaly’s business before buying the stock. In this brand new premium research report on the company, a Fool analyst runs through the dynamics of Annaly’s business, as well as the future opportunities and pitfalls of their strategy. Click here now to claim your copy.

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