Will REITs Kiss High Dividends Goodbye?
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Ben Bernanke’s decision to go ahead with the newest round of quantitative easing was bad news for some market sectors. During the recent FOMC meeting, the Federal Reserve announced they would continue to keep long-term interest rates low by purchasing an additional $40 billion dollars’ worth of agency mortgage-backed securities in addition to the $25 billion per month the Fed was already buying.
But just what is the Federal Reserve buying to the tune of $65 billion per month? They’re buying (with taxpayer dollars) bonds backed by cash flows generated from mortgages that are issued and guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. These three agencies normally issue $120 billion to $125 billion of these bonds per month, and the Federal Reserve will now be the majority owner of these assets.
For mortgage-backed REITs, this decision could put an end to their 10% or higher dividend yield. REITs make money on the yield curve, which is the spread between the interest expense incurred when borrowing money to buy mortgage-backed securities, and the interest income those mortgages generate. When a homeowner refinances at a lower rate, the yield curve starts to flatten out and cut into the REITs profits, and with the Fed adamant about keeping short-term interest rates at about zero through late 2014, this could play havoc with REIT dividends. The REIT also loses out if the homeowner pays off the mortgage early.
Over the last several quarters, purchasers of agency guaranteed mortgages, including Annaly Capital (NYSE: NLY), have reported a narrowing of the spread. With the Fed now the largest single buyer of agency-backed mortgage securities and dedicated to keeping interests low, it may soon become more expensive for REITS to purchasing these securities.
As the largest REIT, Annaly Capital currently holds 92% of its portfolio in fixed-rate mortgage backed securities and agency debentures. The company reported a 2Q 2012 net loss of $91.20 million as compared to 2Q 2011’s net income figure of $120.8 million and 1Q 2012’s net income of $901.80 million. 2Q 2012’s interest rate for earning assets was 3.04%, while the cost of funds interest rate was 1.50%, yielding a spread of 1.54%. This is a full 91 base point drop from 2Q 2011’s spread of 2.45%, and a drop from 1Q 2012’s 1.71% spread.
American Capital Agency (NASDAQ: AGNC), the second largest REIT, also saw a drop in their spread. 2Q 2012’s asset interest rate was 2.73% against a cost of funds of 1.08%, which yielded a net spread of 1.65%, a significant drop when compared to 2Q 2011’s net spread of 2.31% and 3Q 2011’s net spread of 2.14%.
Capstead Mortgage (NYSE: CMO) saw 2Q 2012 revenue rise to $65.787 million from Q1 2012’s $63.136 million, and net income increase to $43.335 million from $42.541, respectively. But Capstead likewise saw a drop in the net spread from 1.83% in 2Q 2011 to 1.50% in 2Q 2012.
The chart below presents a side by side analysis of each company’s financial health.
Ben Bernanke is pulling out every trick he has to keep short and long term interest rates low and this policy may end up working against the REITs. Should the yield curve continue to erode, shareholders may feel the pain of cut dividends and lower dividend yields perhaps as early as 1Q 2013.
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