Will This mREIT Maintain its Healthy 13.5% Dividend Yield in 2013?

Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Federal Reserve's recent quantitative easing has affected the mortgage REIT sector. Lowered interest rates have resulted in some homeowners refinancing their mortgages and reducing profits for mortgage REITs. However, mortgage REITs have been adjusting to the new business environment. Many of these companies have recently reduced dividends to more sustainable levels.  On the flip side, the program also keeps borrowing rates low.

CYS Investments (NYSE: CYS) shares were trading over $14 one month ago, but have since dropped about 10%. The company announced a share repurchase program worth up to $250 million, and this would indicate that management considers the shares to be undervalued. Is CYS Investments undervalued based on current metrics and developments surrounding the company? 

Reasons to Buy CYS

Despite cuts in dividend yields, unless prepayments accelerate or a policy shock or U.S./European downdraft reduces bond yields further, the yield average for the REIT sector will still be above 10%, and CYS sits comfortably above this level at 13.50%. The book value is mark to market and a reasonable reflection of the liquidation values. CYS currently trades around $12.41, compared to a book value of around $14.46. The leverage ratio was 7.7 to 1 at the end of the third quarter of 2012, compared to around 7:1 today for the Agency MBS portfolios. It is true that lower leverage leads to lower earnings and dividends, but it also means less risk in the future. Agency MBS portfolios have relatively low credit risk, which could make them attractive investments should there be more trouble in either the U.S. or the European economies in 2013.

Risks

More homeowners are taking advantage of lower mortgage rates and refinancing, either on their own or through government-sponsored programs like HARP 2.0, which many banks are implementing and ramping up capacity for new mortgages and refinancing. With mREIT investment portfolios full of premium mortgage-backed securities (MBS), these prepayments and refinancing reduce yields and ultimately lead to lower dividends.

The re-election of President Obama has renewed fears that there might be some mass refinancing initiatives beyond HARP involving the forgiveness of principal, thus aggravating the prepayment problem. Another risk involves the replacement of FHA Director Ed DeMarco, an opponent of principal forgiveness and other radical refinancing options favored by leftist housing advocates. These headline risks are contained for the moment because they would involve strained working relationships with the Republicans in Congress. Finally, there is the reinvestment risk caused by the buying of mortgage-backed securities by the Federal Reserve, which has the effect of increasing the prepayment risk while simultaneously keeping long-term yields low. However, this risk is mitigated in the case of CYS and Agency mREITs that specialize in prepayment-protected portfolios where losses are borne by the GSEs and not the Agency mREITs.

Financials

CYS Investments reported third quarter core earnings of $41.2 million, or $0.25 per diluted share. The dividend was $0.45, which was down from the $0.50 dividend in the preceding quarter. 

CYS saw Titan net interest rate spreads in the third quarter in line with the other mREITs. The interest rate spread net of hedges was 1.24% for the third quarter. This was a significant decrease from the 1.71% net spread in the second quarter of 2012. The adjusted interest rate spread net of hedges was 1.41% in the third quarter of 2012. CYS expects near future net spreads to be in the 1.50% to 1.70% range.

The constant prepayment rate (CPR) was approximately 17.3% in the third quarter. This was a decrease from 18.1% in the second quarter. However, CYS expects the CPR to rise slightly in the fourth quarter of 2012. 

Competitors

mREITs that invest only in residential mortgages issued or guaranteed by a government agency include American Capital Agency (NASDAQ: AGNC) and Annaly Capital (NYSE: NLY). Hybrid mREITs that invest in agency and non-agency residential mortgages include American Capital Mortgage (NASDAQ: MTGE), and Two Harbors Investment. American Capital Agency and Newcastle Investment (NYSE: NCT) showed a substantial price premium over book value. Most companies reported steadily increasing book value for each quarter, with Newcastle Investment posting large gains.

American Capital Agency and American Capital Mortgage Investment policies focus on preservation and growth of net asset value as primary investment objectives. mREIT managers are fully aware of the possible effects of QE3 and have adopted different strategies. In 2011, American Capital launched American Capital Mortgage with an investment charter open to agency, non-agency, CMBS, commercial loans and mortgage derivatives. Annaly announced an offer to acquire the remaining shares of Crexus Investment to diversify its portfolio from the agency backed mortgage securities it has relied upon since its inception.

Conclusion

Despite all the problems with quantitative easing and tight net interest margins, I expect to see double digit dividend yields from CYS through 2014.  I recommend income investors consider buying CYS Investments to take advantage of the dividend yields while they last.


jordobivona has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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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