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The Case for Mortgage REITs

The Case for Mortgage REITs
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Wednesday, 04 November 2015 12:51 PM Current | Bio | Archive

2015 has been unkind to the mortgage REIT sector. The iShares Mortgage Real Estate Capped ETF (REM), a basket of the largest and most actively traded mortgage REITs, is down a little over 8% year to date. Including the large dividend, that loss shrinks to about 4%.

But it's been a rough ride, and I haven't seen any indication that it's over.

This is every value investor's frustration: A cheap sector that just keeps getting cheaper.

Consider the case of Annaly Capital Management (NLY), the largest mREIT by market cap. Annaly has spent virtually its entire history as a public company trading above its book value - as it should. As an investor, you should be willing to pay a modest premium for NLY's management expertise and its low cost of capital.

But in 2012, something changed. Investors became less and less willing to pay up for Annaly's shares, and they pushed the price into discount territory. That discount has been widening ever since, and today the company trades for just 80 cents on the dollar.

A discount to book value would imply that management is actually destroying value. And hey, plenty of management teams actually do destroy value. But it's hard to argue that the management teams of the entire sector are destroying value, and yet that's what market prices currently imply. (see slide 31 in my last client presentation).

So, what gives? Why is the market pricing in such doomsday valuations?

You can blame it on two factors:

  • The flat yield curve of recent years caused mREITs to reduce their dividends. Remember, mREITs borrow short term and lend long term, so a flat yield curve reduced the funds available for dividends. Investors, burned by a dividend cut, have responded by dumping the stocks.
  • Fear of the Fed is playing a role as well. Investors...despite all evidence to the contrary...still seem the think the Fed will aggressively raise rates in the months ahead. Higher short-term borrowing costs will further crimp dividend payments.

So, what should we do about it? Are mREITs worth buying at these prices, or is Mr. Market correctly pricing in risk?

I'll allow DoubleLine Capital's Jeffrey Gundlach to answer that question. In Barron's, Gundlach pretty well summed it up:

Annaly is a mortgage REIT (real-estate investment trust). It buys mortgage securities and leverages them, creating interest-rate risk. But I don't expect the Federal Reserve to raise interest rates anytime soon, and long-term rates are range-bound.

In this environment, Annaly's near-12% dividend yield looks stable. Moreover, the price of the shares could rise because Annaly is trading at a substantial discount to the value of its portfolio of assets. The REIT sector broadly has been weak for the past 18 months because of fears the Fed might raise rates.

I agree with Gundlach. Though to be fair, we've both been very early to this party. I've been writing about the attractive pricing in mREITs for well over a year now, and Mr. Gundlach was publicly praising the sector as far back as 2013. We've both been very early to this trade.

Of course, we're also being paid to wait. Mortgage REITs have continued to pay exceptionally high dividends throughout the turbulence of the past few years. And I don't expect that to change anytime soon.

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CharlesSizemore
2015 has been unkind to the mortgage REIT sector. The iShares Mortgage Real Estate Capped ETF (REM), a basket of the largest and most actively traded mortgage REITs, is down a little over 8% year to date.
Mortgage, REITs, Invest, fed
549
2015-51-04
Wednesday, 04 November 2015 12:51 PM
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