Don't Be Shocked by the Fed's Latest Actions

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

Thanks to the improving job scenario and rebounding real estate sector in the U.S., the Federal Reserve recently announced that it could “consider” tapering off its monthly liquidity injections sooner than expected. While this may come as a shocker, I believe that this is a great time to buy REITs.

This is because in its press release, the Fed had stated that it will keep a close eye on the U.S. economic recovery. If all the key sectors continue to rebound, and unemployment rate falls below 7% during 2013, it “could” consider unwinding its quantitative easing over the next year. That is “not” specific by any means, and a lot is depending upon “ifs” and “buts.”

Furthermore, if the Fed pulls the plug on quantitative easing beforehand, liquidity from the economy will be siphoned off by the rising interest rates, which will eventually defeat the whole purpose of QE3 & QE4. In fact, an economic report recently suggested that a rise in interest rates is harmful for the U.S. economy (as interest repayments rise). Thus, it is highly unlikely that the Fed will terminate its stimulus package (soon).

However, the truth is that the market dynamics haven’t changed yet, and the Fed “will” continue to inject $85 billion in the U.S. economy every month, at least during 2013. But in this chaos, almost all REITs have witnessed a spurt of selling, which makes them attractive at the current valuations.

This REIT has a juicy dividend

In my opinion, Apollo Residential Mortgage (NYSE: AMTG) is one of the best REITs out there. With a modest 53% payout ratio, Apollo’s dividend yield stands at a staggering 17.03%. And despite the recent crash in REITs, Apollo’s shares have actually risen fractionally over the last year.

The best thing about this REIT is that it enjoys exceptionally low CPRs, or Conditional Prepayment Rates. With low interest rates and ample liquidity in the U.S. economy, most REITs witnessed a surge in their CPRs. But, Apollo enjoys low prepayment risks because it primarily deals in affordable housing refinancing and has relatively lower exposure to mortgage backed securities.

For the recent quarter, Apollo Residential posted an impressive CPR of 7%, which is significantly lower than most of its peers. Besides that, Apollo Residential also enjoys an extremely high gross margin of 83.8%. With low prepayment risks, significant exposure to HARP, and high margins, Apollo Residential dominates the industry with a high ROE of 21.6%. As a result, its operating cash flow has grown 161% over the last five years, which is faster than most of its peers.

A different story here

However, shares of American Capital Agency (NASDAQ: AGNC) are down nearly 20% over the last year. The REIT posted disappointing results in the previous quarter, which was followed by a consistent decline in its share prices. The main culprit for the decline was the sharp rise in interest rates.

With a debt/equity ratio of 5.96% and interest rates on the rise, one can casually deduce that American Capital is headed for a massive fall. But, the truth is that American Capital is a well diversified REIT. To counter the decline, its management recently announced that it has initiated short positions in Treasury bonds, which hedges out its portfolio to rising interest rates. Besides that, the REIT also reduced its exposure to 30-year bonds to limit its risks from rising interest rates, free-up capital, and to lower its leverage.

Although American Capital Agency recently slashed its quarterly dividend by 16%, its impressive yield of 21.95% is still one of the highest yields existing today. The Street has been cheering dividend cuts throughout the mortgage REIT industry, as it allows companies like American Capital Agency to cope up with shrinking margins.

With hedged positions, a low CPR of 10%, and slashed dividends, I believe that American Capital is is a good stock to hold.

No risk no rewards 

Meanwhile, shares of Annaly Capital Management (NYSE: NLY) have lost around 13% over the last year. Its quarterly CPR of 19% is relatively higher, yet Annaly has been reporting better growth as compared to American Capital. This is because Annaly doesn’t pay a premium (like American Capital) to acquire securities with low prepayment rates.

However, one thing to note here is that if interest rates continue to rise, market liquidity will shrink gradually, which will eventually lower the industry wide conditional prepayment rates. Since Annaly operates with higher than industry average CPRs, the REIT seems to have the highest improvement potential in its CPRs.

One of its main catalysts is its recent acquisition of Crexus. It deals in commercial mortgage backed securities that are backed by federal agencies. Although commercial paper carries greater risk, it also carries better interest spreads and will eventually improve Annaly’s margins. Since Crexus operates with little or no debt, Anally can now leverage further and boost its returns. Besides that, having commercial paper will also diversify Annaly and position it as a hybrid REIT.

At the current price, shares of Annaly Capital yield 14.16% with a payout ratio of 113.4%, and the acquisition of Crexus is expected to further boost Annaly’s dividend payouts.

Conclusion

If interest rates continue to rise, the interest income of REITs will continue to shrink, but their interest spreads will most likely widen. Thus, REITs will be able to operate with better margins without having the need to leverage their operations. Hence, investors should proceed likewise.

Since Apollo Residential and Annaly Capital are hybrid REITs, they have relatively stable top lines due to their presence in the high-margin commercial sector. So, while Apollo Residential offers the resilience of low CPRs and high margins, Annaly Capital complements it with a tremendous improvement potential in its CPRs. Meanwhile, American Capital Agency presents an upside due to its hedged positions, and stands to gain from the rebound in the housing market. Thus, I believe that holding all three REITs is a great way to spread the risks and rewards.

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Piyush Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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