Unless you’ve been living under a rock for the last few days, you’re probably aware of Ben Bernanke’s newest plan to stimulate the economy, via purchases of mortgage-backed securities. Okay, to call the plan new isn’t really fair, as its name QE3 would suggest, but it is slightly different nonetheless, with the Federal Reserve Chairman squarely declaring his commitment to an open-ended policy until significant improvements in the labor market take hold. Additionally, the Fed stated that it would preserve “exceptionally low” interest rates through at least the middle of 2015, compared to its previous estimate of December 2014.
The most obvious consequence of the Fed’s monetary move is the effect that it will have on interest rates, which are causing inflation hawks, to well, worry that Bernanke isn’t doing his job to maintain stable prices over the long run. Meanwhile, others, including Nobel Prize-winning economist Paul Krugman, warn of a “liquidity trap,” where any further monetary stimulation will be in vain, idly sitting on the balance sheets of banks. Nonetheless, there are a few ways that investors can take advantage of QE3, most notably in the mortgage REIT industry.
While it’s tempting to go all-in on real estate by snatching up any publicly traded mREIT or hybrid REIT out there, we’re not recommending that here. In fact, this sort of knee-jerk reaction to QE3 is exactly the wrong thing to do, despite what many on the blogosphere may have you believe. After all, while the Fed’s upcoming round of MBS purchases will obviously boost the values of existing assets within mREITs’ portfolios, it will also tighten the yield spread that allows these organizations to remain profitable. Think of it as a form of price arbitrage: the larger the spread is between a mortgage backed security’s return and short-term interest rates, the more money an mREIT makes.
To alleviate any headaches, we’re going to divide up our analysis into segments from here on out, using metrics that are oft overlooked by the vast majority of mREIT analyses.
1. Constant Prepayment Rate
The longer any economy is in a low interest rate environment, the fewer high-yielding MBS an mREIT can have in its portfolio. That’s why it’s so important to track what percentage of an mREIT’s mortgages are at maturity, through a ratio known as the “constant prepayment rate” (CPR). Reported to the SEC every quarter, CPR is one of the best – and underused – metrics when analyzing mREITs. In short, the lower CPR the better, as mREITs want to hang onto those pre-recession mortgages as long as possible.
As of the end of this year’s second quarter, American Capital Agency Corp. (NASDAQ:AGNC) had a CPR of 12%, far better than competitors like Hatteras Financial Corp. (NYSE:HTS) at 25.7%, Anworth Mortgage Asset Corporation (NYSE:ANH) at 22.0%, Annaly Capital Management, Inc. (NYSE:NLY) at 19%, and Capstead Mortgage Corporation (NYSE:CMO) at 14.5%.
In other words, this means that currently, American Capital Agency only has to replace 12% of its portfolio with little-to-no-yield mortgages, while its average competitor has to replace 20.3% of its portfolio. Clearly, we can see which mREIT is the winner here.
As expected, this advantage can be directly felt by looking at American Capital Agency’s dividend yield, which is 14.5%. This is higher than all of its peers: Hatteras Financial (12.6%), Anworth Mortgage (11.9%), Annaly Capital (13.1%), and Capstead Mortgage (11.8%). The attractiveness of this mREIT doesn’t stop here.
2. Funds from Operations
American Capital Agency has also been growing faster – much faster – than its brethren, and we’re not talking about those boring, recycled metrics like earnings growth, free cash flow growth, etcetera. To put it simply, none of these measurements matter when discussing mREITs. As with the case of the CPR above, most of the methods that should be used to examine this industry are not used, so after reading this, do us a favor: don’t believe any mREIT analysis if it doesn’t mention Funds from Operations (FFO).
Similar to net income, FFO measures an mREIT’s earnings, minus depreciation and property value fluctuations. As the name suggests, FFO indicates how much funding an mREIT has for future dividend payments. When computing the numbers, it seems that American Capital Agency has the advantage once again, as it has grown its FFO by a whopping 1,128.0% a year since 2008, to currently rest at a trailing twelve month total of $2.4 billion. As you can probably guess, this growth is way above the likes of Hatteras Financial (64.8%), Anworth Mortgage (16.8%), Annaly Capital (21.8%), and Capstead Mortgage (8.6%).
3. Price-to-FFO Valuation
Last but not least, it’s crucial to determine how investors are valuing an mREIT’s Funds from Operations in a way similar to how earnings valuations are calculated. To do this, we can use the Price-to-FFO ratio, which is similar to the Price-to-Earnings ratio, except FFO is in the denominator. Based on trailing twelve-month totals, American Capital Agency currently sports a P/FFO of 2.5X, lower than all of its competitors by an average discount of 16.7%. Annaly Capital is the most overvalued mREIT of this particular bunch, with a P/FFO of 4.3X.
In the hedge fund industry, the sentiment surrounding American Capital Agency has been moderately strong, with 20 managers holding shares of the mREIT at the end of Q2 2012. Some of the most prominent bulls are Bain Capital’s Brookside Capital, Richard Driehaus, Ken Griffin, and Cliff Asness. As discussed above, it’s likely that these funds have taken notice of American Capital Agency’s domination in just about every mREIT-specific category out there, from its extremely low constant prepayment rate, to its favorable P/FFO valuation. For a complete look at the hedge fund industry’s holdings, continue reading here, and remember: use these metrics when analyzing mREITs in the future. They may just help you ride out QE3 to a nice, cozy retirement on an island somewhere, or even better, pay for your kids’ college.
