REIT Investing in Focus: Armour Residential

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Investors looking for income investments with a reasonable return have had to expand their investment choices well beyond traditional investments to generate the income they desire. Given the low interest rate environment and the meager returns on conventional fixed income securities, it has become difficult to find satisfactory investment alternatives. There has been an increasing reliance on REITs because of the high dividend yields that are available. Mortgage REITs pay some of the highest dividends of any equities. However, investors should understand the risks they are taking in order to generate those returns and which mREITs are using strategies and risk management to limit the risks inherent in their strategies.

The best way to understand how to invest in the REIT sector is to analyze the operations of one mortgage REIT. Today I will analyze ARMOUR Residential REIT (NYSE: ARR)Estimated taxable REIT income for the third quarter ended September 30 was approximately $86.4 million and the weighted average additional paid-in capital for the quarter was $1.93 billion. The estimated taxable REIT income works out to an annualized return on weighted average additional paid-in capital for the quarter of 17.9%. The company distributes dividends based on its estimate of taxable earnings per common share and not on earnings calculated in accordance with Generally Accepted Accounting Principles (GAAP). You will remember that mortgage REITs have to distribute at least 90% of their taxable income to maintain their tax-free status. The difference between Taxable REIT income and GAAP earnings arises principally because of the non-taxable unrealized changes in the value of its derivatives, which are used as hedges. Unrealized gains and losses are included in GAAP earnings, but not in taxable income.

Estimated core income for the quarter ended September 30, was approximately $71.4 million. "Core Income" is a non-GAAP measure and is defined as net income excluding impairment losses, gains or losses on sales of securities and early termination of derivatives, unrealized gains or losses on derivatives and certain non-recurring expenses. Core Income may also differ from GAAP earnings because GAAP earnings include the unrealized change in the value of derivatives. For computing GAAP net income, the change in fair value of the company's derivatives is reflected in current period net income, while the change in fair value of its Agency Securities is reflected in its condensed consolidated statement of comprehensive income. Due to the decline in interest rates during the quarter, the corresponding unrealized loss on derivatives was $31.5 million and GAAP net income for the quarter was $54.9 million. For the quarter, the company declared dividends of $0.10 per outstanding share of common stock for each month of the quarter resulting in payments to common stockholders of $84.5 million.

ARMOUR's portfolio consisted of Fannie Mae, Freddie Mac and Ginnie Mae mortgage securities and was valued at $22.1 billion as of September 30. During this quarter, the annualized yield on average assets was 2.70%, and the annualized cost of funds on average liabilities was 0.89% resulting in a net interest spread of 1.82% for the quarter. As of September 30 the company financed its portfolio with approximately $19.8 billion of borrowings under repurchase agreements. The debt/equity ratio as of September 30 was 8.93 to 1. The $22.1 billion portfolio of agency securities on September 30 consisted of 89.2% fixed rate Agency Securities and 10.8% ARMs and Hybrid ARMs. The company defines "Hybrid ARMs" as adjustable rate Agency Securities with longer than 18 months to rate reset and "ARMs" as adjustable Agency Securities with rate resets shorter than 19 months.

Now let us see what insights we can draw from these numbers. One of the biggest risks that any mortgage REIT faces is interest rate risk both in respect of the cost of its borrowings and the yield on its investment portfolio. Both these are affected by sudden or sharp movements in interest rates. Like its peers American Capital Agency (NASDAQ: AGNC) and Annaly Capital Management (NYSE: NLY), ARMOUR makes its money by profiting from the difference between lower short-term borrowing rates and the higher long-term yields from its portfolio of mortgage-backed securities. However in view of the stance of the Fed, interest rates are expected to remain low at least till some time in 2015 and the interest spread earned by mortgage REITs will be protected until then. This is further reinforced by the composition of the ARMOUR investment portfolio of mortgage-backed securities that consists of securities either issued or insured by Fannie Mae, Freddie Mac, and Ginnie Mae which are relatively low-risk investments because of the federal agency backing.

To add to the stability of earnings the company has been focusing on fixed-rate securities. In 2011, less than half of ARMOUR's portfolio was in fixed rate securities and this has been increased to approximately 80% now. The Constant Prepayment Rate is currently at around 9% down from a peak of over 19% earlier. Though the company has cut its dividend by 10%, the dividend yield at over 14% is still very attractive.

Annaly Capital Management, one of the largest and best managed REITs, is implementing a change in its strategy with the proposed acquisition of Crexus Investment (NYSE: CXS.DL).

Crexus recently confirmed that its Board of Directors received a proposal letter from Annaly Capital Management with intent to "acquire all of the outstanding shares of Common Stock of Crexus not currently owned by Annaly Capital Management for $12.50 per share in cash". Annaly Capital Management currently owns around 12.4% of Crexus’ Common Stock. Crexus largely invests in commercial real estate, including commercial mortgage loans and commercial mortgage backed securities. This would result in a diversification of its investment portfolio, and makes Annaly Capital Management a more attractive investment. 9% of American Capital Agency's MBS portfolio of $7 billion is backed by fixed-rate agency securities and 11% adjustable rate securities. When you consider that its weighted average cost basis on its investment portfolio was 105.3% as of September 30th, 2012, the company will need to maintain a focus on minimizing prepayment risk.

You may be able to find mortgage REITs that can give you a higher yield, but this is normally because they invest in riskier assets such as distressed debt and credit sensitive assets such as non-agency mortgage backed securities. You will be taking a higher risk for the higher return. ARMOUR offers an excellent trade-off between risk and reward, and the dividend yield appears to be safe until 2015. I would not recommend mortgage REITs stocks as desirable long-term income investments but, as long as the current stable and low rate of interest rate regime continues, there is no reason why you should not jump on the bandwagon and take advantage of the dividend yield.

StockCroc1 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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