mREITs are the most favored alternative for fixed income instruments, given that 10-year Treasuries are offering only little above 2%. Money managers and sophisticated traders own only a negligible part of the mREITs now. Since mREITs operate under a complex business model, retail investors must understand that they will be in the direct line of fire in the event that the sector experiences rapid losses. Let’s see what makes this complicated business model even more prone to changes in interest rates.
Complicated business model
Mortgage real estate trusts (mREITs) are companies with special corporate structures that invest in mortgage backed securities (MBS) to earn a spread over their cost of funds. Mortgage yields are directly linked with MBS spreads. Ben Bernanke’s recent speech signaled that the Fed might be tapering its easing programs sooner than expected. Pricing in the signals, the markets have seen an increase in the rates, causing agency MBS spreads to increase 18 bps to 67 bps.
While this should be a positive sign, shares of mREITs have skydived. This is because the widening of the spreads also causes the book value of the mREITs’ assets to depreciate. Therefore, securing the book values should be among the key priorities of management. Note that this messy situation also demonstrates how complicated the mREIT business model is.
Retail investors are heavily invested
The complicated mREIT business model and ARMOUR Residential’s poor performance has led his co-CEO to say that mREITs are not appropriate for individual investors. mREITs are typically favored by individual or retail investors due to their elevated dividends yields. Google Finance reports 29% institutional ownership in ARMOUR Residential, which means the rest are individual investors.
Looking at the competitors, around 58% of the investors are retail investors in American Capital Agency Corp. (NASDAQ:AGNC), while 57% of the investors in Annaly Capital Management, Inc. (NYSE:NLY) are individual investors. This reflects the individual investors are exposed to risk that they might not be aware of.
High leverage and sensitivity to interest rates
Higher levels of debt (leverage) in the capital structures of mREITs, coupled with the bottom line’s sensitivity to changes in interest rates could lead to significant losses. Among pure-play mREITs, ARMOUR Residential has the highest amount of debt in its capital structure, as measured by its leverage ratio (debt-to-equity) of around 9.16 times. This is one reason why the company has seen so much volatility in its financial results over the past couple of quarters. I believe if the company continues to maintain this leverage, you should expect more volatility. Further, a 50 bps increase in the rates can cause the company to report 4.16% drop in the coming quarter’s net interest income.
In contrast, American Capital Agency Corp. (NASDAQ:AGNC) employs 5.9 times debt to equity (leverage), while Annaly Capital Management, Inc. (NYSE:NLY) reported leverage of 6.7 times. These numbers are relatively low, which may cause less volatility in the results of both the companies. Furthermore, Annaly Capital reports that its coming quarter’s interest income is positively linked to changes in interest rates. Annaly Capital Management, Inc. (NYSE:NLY)’s interest income will increase 17% if the rates climb 50 bps. However, American Capital Agency Corp. (NASDAQ:AGNC) reports a negative relationship. Its projected interest income will plunge 4.3% if the rates increase 50 bps.
In short, ARMOUR is the least favored with highest leverage and highest interest rate sensitivity, while Annaly Capital Management, Inc. (NYSE:NLY) is the most favored.
Investment thesis
Annaly Capital Management, my favorite mREIT, is currently trading at an 11% discount to its book value, while American Capital Agency and ARMOUR Residential are trading at 12% and 32% discounts, respectively.
Since Annaly Capital Management, Inc. (NYSE:NLY)’s net interest income is positively linked to changes in interest rates and it has other positive stock price drivers, I believe now is an appropriate entry point. However, ARMOUR and American Capital Agency Corp. (NASDAQ:AGNC) have no positive stock price drivers. Therefore, I recommend investors stay away from both the stocks until the Fed finally exits the Agency MBS market.
Further, I believe proper due diligence could lead to a thorough understanding of the mREIT business model and fewer losses for the retail investors.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
The article What Makes mREITs Inappropriate for Retail Investors? originally appeared on Fool.com and is written by Adnan Khan.
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