Why mREITs Will Fly High In 1Q13

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Editor's Note: The initial version stated Annaly and American Capital reported earnings, that is incorrect. Motley Fool apologizes for the error. This version has been corrected.

The US mortgage rates continue to climb higher and higher since the beginning of the year 2013, increasing borrowing cost for potential home owners despite Fed’s commitment to keep home loans affordable.  Home prices are increasing across the US as improving employment and relatively low interest rates are boosting demand.

The average 30-year fixed rate mortgage edged up to 3.42% this week, up from 3.38% and the highest since September. Similarly, the average 15-year rate increased from 2.64% at the start of 2013 to 2.71% today. It is believed the improvement in the US labor markets is part of the reason for such a surge in mortgage rates and increase in home prices. Data suggest the economy entered the year with some momentum. A report from the Labor Department demonstrates the initial claims for state unemployment benefits fell by 5000 to 330000, the lowest since January 2008. Similarly, the four-week moving average for new claims fell 8250 to 351,750, the lowest since March 2008. This improvement is boosting demand for housing, which is increasing the home prices and mortgage rates. Federal Housing Finance Agency released data which says US home price increase 5.6% in the past 12 months.

The improvement in the US labor market and the resultant surge in mortgage rates are creating a healthy environment for mortgage REITs. Mortgage REITs finance their investments in mortgage backed securities and earn a spread between their interest yielding assets and their interest bearing assets. The surge in short-term rates nowhere in sight coupled with increasing long term rates (at which mREITs invest), provide mortgage REITs with a widened spread. Besides, the widening of spreads, Agency mortgage REITs can expect prepayments to slow down as rates increase. This widened spread and slowdown in prepayments provide mREITs with a breath of relief during such challenging times, when the Fed is aggressively buying both treasuries and mortgage backed securities on a monthly basis. Under the situation the three mortgage REITs to be considered for long positions are Annaly Capital Management (NYSE: NLY), American Capital Agency (NASDAQ: AGNC) and Armour Residential (NYSE: ARR). All three of the above mentioned mortgage REITs have exclusive investments in Agency mortgage backed securities and seen substantial decline in their interest rate spreads and interest incomes.

Annaly Capital Management

Annaly Capital has a history of paying elevated dividends since 2000. Currently, the company offers a quarterly dividend of $0.45 per common share, down from $0.50 per common share. This is a dividend yield of 12.15%. The company paid $1.64 billion, while it generated $7.28 billion during the third quarter of the prior year. The company reported a CPR of 20%, which I believe will come down during the first quarter of the current year.

American Capital Agency

American Capital Agency is one of the very few Agency mortgage REITs that was able to sustain its quarterly dividend distribution under such challenging macroeconomic environment. Throughout the year 2012, AGNC distributed $1.25 per common share yielding 15.8%. The company paid $384 million in dividends, while it generated $597 million in operating cash flow during the third quarter of the prior year. The company reported a CPR of 12%, which is expected to come down this quarter. The company is considered to have a prepayment protected MBS portfolio with low coupons and loans with low balances.

Armour Residential

Armour Residential invests in fixed rate, adjustable rate, and hybrid mortgage backed securities. Contrary to NLY and AGNC, Armour distributes dividends on a monthly basis. The company is currently offering monthly dividends of $0.08 per common share, down from $0.09 per common share in December 2012. The stock currently yields 13.8% and paid $85 million in dividends, while it generated $106 million in cash from its operations. The company reported a CPR of 13% for its MBS portfolio at the end of 3Q. The company invests in MBS with prepayment protected characteristics. A large proportion of the MBS in the company’s holdings are 15-year MBS.


I believe if the US labor markets continue improving, mortgage rates will continue their upward trend. This upward trend in mortgage rates will bring down prepayments and widen the spreads for the aforementioned mortgage REITs. Therefore, I believe investors should buy NLY, AGNC and ARR and benefit from their elevated dividends. 

Vamosrafa7 has no position in any stocks mentioned. The Motley Fool owns shares of Annaly Capital Management. 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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