Today I want to delve into a widely misunderstood part of the market – mortgage REITs. This misunderstanding creates some great opportunities for income investors to enhance returns and income without taking on much more risk. I’ll focus my discussion on the biggest and best of the mortgage REITs, Annaly Capital Management Inc, symbol NLY.
Mortgage REITs are real estate investment trusts that invest in mortgages, usually through mortgage backed securities. The basic business model is the same for all of them. They invest in mortgage backed securities at a certain yield. They use leverage on their equity to fund those investments. The difference between what their mortgage investments yield and the cost of the debt is how much money they make, or the interest rate spread (or margin). Because of the leverage even a small interest rate spread can generate good returns on equity. For example, with a portfolio of mortgages the yield 6%, and interest rate spread of 1%, and a leverage of 8x, a mortgage REIT would generate an ROE of 14%. Annaly has a great discussion of their business model on their website. The important point here is that the amount of money the mortgage REIT makes is dependent on the interest rate spread which varies over time. Also, as REITs these companies must pay 90% of their earnings out to shareholders so they are very much income investments and in general are high yielders as well. For example, the iShares mortgage REIT ETF, REM, currently yields around 10%. Annaly currently yields about 14%.
The misunderstanding of mortgage REITs stems from a few widely held beliefs regarding dividend investments. Mainly the view that very high dividend yielding stocks are risky and dangerous and that stocks whose dividends fluctuate are not good investments as well. These beliefs have a strong base in reality as very high yields often do indicate that a company is in trouble and also stocks that cut their dividends in general do not perform well. But that is not always the case. There are exceptions to every rule. What if these two attributes are inherently part of the business model of a company? In that case, maybe the traditional view is not warranted and these investments need to be looked at differently. I think that is the case with mortgage REITs. If approached from the right perspective they can be great investments. Investors need to remember that mortgage REIT dividends will fluctuate and so will there dividend yields. From a total return perspective they can be quite compelling. Lets look at Annaly in more detail.
Annaly came public in 1997 and since that time it has been a terrific investment. Since inception, 1997, it has provided a return to shareholders of 16% per year compared to about 6% per year for the S&P500. During this time it has yielded anywhere from the mid teens down to 4-5%. On average over its lifetime its yield has been around 12%. The chart below shows Annaly’s total return performance (right axis) versus the spread between the 1oyr and 2yr note (left axis), a proxy for its interest rate margin.
As the chart shows, Annaly has been through good times (high spreads) and bad times (low spreads) providing solid investment returns over mortgage cycles. It also survived the worst credit crisis, 2008, since the Great Depression. Did these returns come at higher risk? I don’t think so. Using the traditional measure of risk, volatility, Annaly’s volatility since inception has been 25% annualized vs 18% for the S&P500. That extra risk from the increased volatility came with a benefit of 2.5x the return of the S&P500. Using another measure of risk, maximum drawdown, Annaly’s maximum drawdown has been 40% vs over 50% for the S&P500. From the drawdown perspective Annaly was less risky than the index. All in all a pretty compelling risk reward trade off in my opinion.
I’ve focused on Annaly in this post because they are the biggest mortgage REIT, have a long track record over various mortgage cycles, and have a great management team. There are other good mortgage REITs out there as well. Also, the mortgage REIT space has become quite diverse. There are REITs that focus only on agency mortgages, those that do mainly non-agency, those that focused on fixed rate mortgages, those that focus on ARMs and hybrid mortgages, etc… There’s something in this space for all kinds of investors with various outlooks. Besides Annaly I also like Chimera (CIM). They are the subsidiary of Annaly the focuses on non-agency REITs.
In summary, approached from the right perspective mortgage REITs can make compelling additions to an income investor’s portfolio. Income investors need to remember that mortgage REIT dividends will fluctuate up and down with the mortgage cycle. While they are not suited for the core part of a dividend portfolio I think they are great peripheral additions that can both enhance yield and raise returns of an income portfolio.
Disclosure: long CIM
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.