In light of the sell-off in Mortgage Real Estate Investment Trusts (mREIT) over the past month, now might be a good time to take a look at three ideas within the sector. In this post, I will take a look at total returns, dividend yields, and current trading valuations of three mREITs.
For those who are not acquainted with the Real Estate Investment Trust industry, unlike Hybrid mREITs, Agency mREITs can only buy mortgages from government sponsored agencies (such as FannieMae). Hence, the assets these funds buy are free from default risks. As a result, Agency mREITs can afford to have much more leverage than Hybrid mREITs. Let’s take a look at the agency mREITs first.
Two Agency REITs
American Capital Agency Corp. (NASDAQ:AGNC) is my top pick among the trusts that acquire mortgages from government sponsored agencies. If you had invested in this agency mortgage REIT five years ago and re-invested all dividends, your total return would be just above 248%.
The fund’s leverage is still high, but it has been reducing its leverage at a good speed from 7.1x to 5.8x in just six months. Its current dividend yield is huge at above 18%, and it is now trading at 91% of its book value. Among its peer group, I think this Agency mREIT is a great alternative given its relatively lower leverage and high cash dividend yield. In the future, I would expect the leverage (and cash yield) from this instrument to keep falling down to at least 4x.
The reason is simple: interest rates in the U.S. are poised to increase as the Federal Reserve eases its expansionary monetary policy. Higher rates will put an end to ultra-cheap financing and will make the price of fixed rate mortgages drop. As a result, for funds that buy fixed rate mortgages, high leverage ratios could be dangerous. According to the mortgage team at Oppenheimer, the long-term cash yield from this instrument shall be at around 17%. I would assign American Capital Agency Corp. (NASDAQ:AGNC) a portfolio weight of 35%.
Hatteras Financial Corp. (NYSE:HTS) is my second favorite pick among the Agency mortgage trusts. The fund is leveraged 7.4x, and has had a total return (with dividends re-invested) of 96% over the last five years. Hatteras has had a constant leverage ratio for over six months now, and I would expect the fund to start reducing its leverage as U.S. yields (and the cost of leverage) increase.
As I explained in American Capital Agency Corp. (NASDAQ:AGNC)’s case, as the leverage from the fund is reduced, we should also expect the cash yield to diminish. That said, given that Hatteras Financial Corp. (NYSE:HTS) invests in adjustable-rate single-family residential mortgages, a fall in the price of fixed rate mortgages should not severely affect it. Given that it buys adjustable-rate mortgages, I am sure that Hatteras will be able to sustain its leverage level well above 5x.
According to the mortgage team at Oppenheimer, the long-term cash yield from this instrument should remain around 11%, even with a reduced leverage level. I would assign Hatteras Financial Corp. (NYSE:HTS) a portfolio weight of 15%. The reason to assign such a low weight to Hatteras is that, despite being a great income generator, American Capital Agency Corp. (NASDAQ:AGNC)’s yield is too compelling for anyone to ignore.
One un-leveraged play within the hybrid mortgage real estate trusts
Within the Hybrids, my favorite play is PennyMac Mortgage Investment Trust (NYSE:PMT). PennyMac is the best risk/reward option I could find in the industry. The company has increased its leverage over the last six months from 0.9x to 1.3x, but my best guess is that leverage will not go above 1.5x, at least in the medium term. If you had bought the REIT two years ago and re-invested all dividends, you would have achieved to gain of more than 60%.
Yielding 10% and selling for 107% of its book value, I think PennyMac is a great idea taking into account to current recovery in the U.S. housing market since the it focuses on investing in distressed loans, which are the most exposed to a U.S. housing recovery. According to the mortgage team at Oppenheimer, the long-term yield of this company should be around 12%.
Taking all the above into account, I would assign PennyMac a portfolio weight of 50%.
Bottom line
The three trusts named above offer great returns and they are among the least leveraged plays within their peer groups. Besides, they trade at relatively low book value multiples and they have been among the best performers. The portfolio that I assembled in this post will provide your overall portfolio with a high long-term expected yield of 13.6% without the over-leverage that usually comes with agency MREITs.
Federico Zaldua has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Real Estate Investments: A Mortgage REIT Portfolio originally appeared on Fool.com.
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