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
20 Comments
doug nashif · February 10, 2011 at 9:04 pm
Thanks for the great blog. I would like to subscribe via the RSS feed but the link appears to be broken or disabled. In the meantime I have subscribed to your email notification but thought you might appreciate knowing about the RSS button.
libertatemamo · February 10, 2011 at 9:43 pm
Thanks Doug. I’ll check the RSS link.
jim goldstein · February 12, 2011 at 9:09 am
I have owned NLY since 2007 and have done great with it. Unfortunately, I only bought 500 shares and never bought more. Still holding though and the dividend has been amazing. I am a little tentative on CIM as being the poor cousin mentality on my part. James Grant recently spoke about NLY and MFA as being great investments even though not without risk. Thanks Doug for another informative article. Jim
libertatemamo · February 12, 2011 at 9:35 am
Hi Jim. In a way CIM is a poor cousin of NLY but I think the term younger sibling is more accurate. This young sibling likes a bit more risk so it goes out into the non-agency MBS market, i.e. no gov’t guarantee. And of course it earns more money by doing this as evident by their much higher interest rate spread. But having the prudent parent watching over them, they take on much less leverage (less than 2x). Also what I like about CIM vs other non-agency REITs is the fact that NLY is a key funding source during bad times. NLY stepped into the break in 2008 and full supported their young offspring with an equity injection when the market went berserk.
I think they are both outstanding investments. CIM is a bit higher risk but you get 2-3% higher yield for it. They are both worth owning imo. On the NLY front I’ll be interested to see what their response is to the gov’t proposal to get out or reduce their involvement in the mortgage market.
Paul
jim goldstein · February 15, 2011 at 9:48 am
I noticed that NLY really got hammered yesterday. It seems to happen every time they offer more shares at a price lower than market. What is their thinking on this if you know. Thanks. Jim
libertatemamo · February 15, 2011 at 10:54 am
Jim, the first reason the price goes down when more shares are offered is that the earnings of the company are now diluted over a greater number of shares and it usually, for normal companies, takes time for that incremental capital to start generating earnings. Also, since some investment back needs to underwrite the shares and make sure they get sold, etc…, they need to get paid and they want a little lower price for their big clients probably so usually the offering gets made a bit below market to make sure there is enough demand for the new shares.
For NLY, and other mortgage REITs, since they have no retained earnings issuing additional shares is the only way to raise capital. They then go to the debt market to leverage the capital raise up to their desired leverage ration (currently about 7 to 1). Then they invest the additional capital buy buying more agency mortgages. What’s great about the mortgage market is that the additional capital goes to work right away and starts earning interest asap. No need to wait.
Usually for NLY, additional capital raises are a very positive sign that they see great investment opportunities right now. I’ve been meaning to post on their most recent earnings announcement bit haven’t had the chance yet. If you have the chance listed to their Q410 earnings call. Well worth it.
Paul
kim · April 2, 2011 at 12:04 pm
what are increasing interest rates going to do to
reits over the next 2 years
what percentage of downside to shareprice?
thanks, kim
libertatemamo · April 3, 2011 at 4:22 pm
Hi Kim. It’s not a simple answer unfortunately it varies by mortgage REIT. Good thing is that every mortgage REIT publishes the impact of changing rates (rising or falling) on their book value. In every 10-Q for a mortgage REIT you can find a table that shows you the impact a rise or fall of X% would have on their book value. For example, for NLY’s portfolio interest rates going up would cause their book value to go down. For CIM, rising rates would cause their book value to increase. It all depends on the types and structure of the loans they hold. So, every individual REIT is different.
The thing to watch is not an absolute rise in rates but watch their interest rate spread instead, the difference between the yield of their portfolio and their cost of funds. That’s the key. If and when that spread goes down by a lot then mortgage REITs will have more trouble making money. From my personal experience, things tend to be OK until spread get to 1% or less. Once spreads fall to 1% or less, REIT stock prices in general start to suffer since they are highly tied to their book values.
Hope that helps. Its’ not black and white.
Paul
Tony · April 5, 2011 at 12:45 am
Can anyone explain why (how) CIM has a negative duration? Does it hedge against rising interest rate?
libertatemamo · April 5, 2011 at 4:17 pm
Tony, great question. There are a couple of ways a mortgage REIT can have negative duration. One, invest in adjustable rate mortgages. At the end of 2010, 49% of CIM’s portfolio was in adjustable rate mortgages. Two, hedge interest rate risk with swaps. For example, if they are concerned about rising rates on their cost of funds, they can enter into interest rate swaps that exchange floating rate payments for fixed payments. They can do the same thing on the asset side to hedge risk in their fixed rate mortgage investments.
Hope that helps.
Paul
Tony · April 5, 2011 at 10:14 pm
Thank you Paul.
I would tend to think adjustable rate mortgage becomes more risky (more defaults) in a rising interest rate environment. On the other hand, currently CIM investors get well compensated for such risk with 14% yield.
I discovered your website a couple days ago. Good website; I love it. Thank you for sharing your ideas and thoughts.
libertatemamo · April 6, 2011 at 6:27 pm
True Tony. But when interest rate on the adjustable mortgage goes up, CIM makes more money. Yes, defaults may go up but they prob don’t go up enough to eat away the extra income if the mortgages were bought prudently. CIM lists out the credit scores of all their mortgage holdings so you can see how their portfolio looks credit wise. These guys are good at what they do – they are basically run by the same team that runs NLY, the best mortgage REIT around.
Paul
george e croom · August 13, 2011 at 3:19 pm
how,will NLY do going forward if the fed keeps it`s promise to keep interest rates low for the next two years? will such a policy be help full or harmful?
libertatemamo · August 14, 2011 at 11:11 am
The fed decision is a license to print money for all mortgage REITs.
reotokate · September 17, 2011 at 2:04 pm
Great post! I’m a student taking a REIT analysis class now. This post helps a lot. Would you mind elaborating on “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%. ” more? how to derive the 14% ROE? Thank you!
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