When Fed chiefs Ben Bernanke and Janet Yellen promised the markets that interest rates would stay low for a long time, it sent an important signal to many companies and investors. That’s because any company that borrows money at low rates and then uses it to invest in higher-yielding instruments is working on what’s called an “interest rate spread”.
The higher the borrowing costs, the less the spread, meaning the less profit there is, and the smaller the distributions are of that company to shareholders.
mREITs are one such investment. They borrow money at low interest rates and then buy bundles of securities. These securities are backed by mortgages. In the post-housing crisis, mREITs have scared many investors, fearing toxic mortgages. The good news is most mREITs know all about toxic mortgages and have gotten far better at underwriting.
mREITs must pay out 90% of their earnings to investors. That’s why they are attractive to fixed-income investors, although they can make retirement investors happy also. The latter is just more conservative so the risk associated with the mREITs keeps some older investors on the sidelines.
However, the interest rate risk isn’t gigantic, exactly because the Fed has promised to keep rates low for awhile. Thus, the interest rate risk associated with these investments is much lower.
The good news is the Fed’s QE programs were really about long-term rates, so ending that program hasn’t been the end of the world. It’s short term rates that mREITs are more concerned about.
The safest mREITs are “agency mREITs”, and the reason for their relative safety is that they are guaranteed by the federal government in the form of the Fannie Mae and Freddie Mac. Yes, they still exist, despite enduring gazillions of dollars in losses during the financial crisis.
The federal guarantee means default risk on this type of mortgage is next to nothing. Lower risk translates to lower yields.
However, now is a great time to buy in. Most mREITs are trading as much as 20% below book value, or the value of the loan portfolio they own.
Annaly Capital Management (NYSE:NLY) is the largest, most well-known mREIT.
What you’ll quickly learn is that EPS isn’t the way to judge valuation. NLY is constantly recording extraordinary gains or losses on securities or interest-rate swaps (derivatives that hedge against interest rate increases). Cash flow is what matters, and you want cash flow since that is what fuels your dividend. TTM cash flow is well into the billions, so it’s more than enough to pay its 10.7% yield.
Chimera Investment (NYSE:CIM) owns both agency-backed mortgages and non-agency-backed mortgages, so there is more risk here. The key with non-agency mortgages is even more selective underwriting.
Chimera is a subsidiary of Annaly and because its portfolio is managed by one of Annaly’s divisions, you get the Annaly expertise. Chimera does not have as much debt as NLY, so that helps offset the risk of non-agency mortgages. Because there is more risk, then there are wider spreads, which range from 4.7% to 6.1%. You also collect a 11.2% yield.
The stock is trading around $3 per share. There’s a lot of skepticism surrounding the stock, and I think if you buy in, you have the largest possible reward. Still, there is risk here and it’s a speculative play.
Back on the safer side, Hatteras Financial Group (NYSE:HTS) also trades right around book, at about 82% of book value. It’s leveraged at about 6.7x vs. Annaly’s more modest 5.5x and pays 11.3%.
The attractive factor here is that the company is tied to a lot of adjustable rate mortgages. That doesn’t mean there’s interest rate borrowing risk. In fact, the adjustable mortgages means that if rates increase on the borrowing side, they also increase on the collections side.
Finally, if you want safety and diversity, go with an ETF. The iShares FTSE NAREIT Mortgage ETF (NYSE:REM) has exposure to 36 mREITs and is close to a yearly low.
Lawrence Meyers has no position in any company mentioned.
This article is brought to you courtesy of Lawrence Meyers from Wyatt Investment Research.