Time to reconsider mortgage REITs for income?

By Xavier Brenner

mortgage-reits

Last year, investors spurned mortgage real estate investments trusts (mREITs) in a big way when it became clear in May that the U.S. Federal Reserve would start withdrawing liquidity from the bond market and gradually move toward a tighter monetary policy.

As a result, mortgage rates took off and mREITs prices were crushed.

In 2014, the Fed continues to taper its monthly bond purchases and mortgage rates remain elevated. However, these hybrid securities that trade like stocks and invest in mortgage bonds are back in fashion.

Why? U.S. and emerging market stocks are down on the year, while ten-year Treasuries are yielding all of 2.6%. In stark contrast, although dividends reflect past performance, some of the biggest mREITs are boasting dividend yields in the 11%-plus range.

US 30 Year Mortgage Rate Chart

US 30 Year Mortgage Rate data by YCharts

Those double-digit yields come with risk. Mortgage REITs generate income by borrowing at short-term rates and investing in higher-yielding mortgage-backed securities. Rising interest rates force mortgage REITs to pay higher hedging costs, reduce leverage and pay lower dividends, making these investments less attractive to investors.

On the other hand, some optimistic analysts argue that last's year sell-off was so brutal that many of mREIT stocks are trading at a discount to their per-share book value. Those discounts, plus dividends and attractive yields, offer up an opportunity, in their view.

With the S&P 500 Index (SPX) and Dow Jones Industrial Average (DJIA) in negative territory through February 10, investors seem to be warming up to these securities once more. Annaly Capital Management (NLY), the largest mREIT with a $9 billion market cap, is up about 7% on the year and yields about 11%. (See next chart.) The American Capital Agency Corp. (AGNC) mREIT yields close to 12% and is up over 14%. The broader Bloomberg Mortgage REIT Index is up about 7%.

Michael Widner, a REIT analyst at KBW Bank, told Bloomberg in mid-January that he thinks the mREIT sector is poised to deliver returns over 20% this year thanks to discount to book value in these securities underlying bond portfolio plus their generous yield.

It's also unclear that a higher interest interest rate environment is necessarily bad for mREITs. The National Association of Real Estate Investment Trusts late last year issued a report titled: The National Urban Legend: The Myth of REIT Interest Rate Sensitivity. The group noted 16 periods since 1995 when interest rates rose sharply, but REITs still performed well.

Darren McCammon, who manages the Fifty Plus portfolio on Covestor, was bullish on the mREIT sector as early as last October. While acknowledging some risks, he pointed out that many mREITs had been heavily discounted by a sharp downturn in their prices. As McCammon pointed out:

"The discounts should shrink over time producing capital gains. Fear has created an opportunity; mREITs represent not only high dividends but their current discounts provide a margin of error. As such they should be over-weighted in income focused portfolios."

Some mortgage REITs have fallen so hard that companies in the sector have started buying competitors’ shares, according to a WSJ.com. report.

Photo Credit: LendingMemo

DISCLAIMER: The information in this material is not intended to be personalized financial advice and should not be solely relied on for making financial decisions. The investments discussed are held in client accounts as of January 31, 2013. These investments may or may not be currently held in client accounts. REITs may be affected by economic conditions including credit and interest rate risks, as well as risks associated with small- and mid-cap investments. Dividends reflect past performance and there is no guarantee they will continue to be paid. Past performance is no guarantee of future results.