The key to the mortgage REIT sector right now is the preservation of book value. Given the relative strength of the non-Agency MBS market, hybrid mREITs have been able to withstand the volatility of the market better. Therefore, this protection of book value leaves the hybrid mREITs in a better position to continue to deliver returns and potentially take advantage of the better spread environment on Agency MBS today than their pure-play counterparts. Among the residential hybrids, Two Harbors Investment Corp (NYSE:TWO) remains my top pick. Now, the mREITs business model is complicated. This article aims to educated potential investors about it and see why Two Harbors remains my top pick.
What is an mREIT?
Real estate investment trusts that invest in mortgage backed securities are called mREITs. They invest in longer duration MBS using short-term financing (repos) and earn a spread between what they earn on their interest earnings assets (MBS) and what they pay on their interest bearing liabilities (repos). The spread is leveraged to magnify the returns.
What is an Agency mREIT?
Agency mREITs are companies that invest in mortgage backed securities for which any of the government Agencies such as Fannie Mae and Freddie Mac guarantee the principal and interest payment on the MBS held. These MBS are usually backed with single-family residential mortgage loans.
What is a hybrid mREIT?
Like Agency mREITs, hybrids invest in Agency RMBS. However, they have non-Agency MBS, commercial mortgage backed securities (CMBS) and a variety of other real estate related assets in their investment portfolios. Non-Agency MBS are MBS issued by private mortgage originators while commercial MBS are backed with commercial loans, instead of residential loans.
Why I prefer hybrids
As noted above, hybrids are invested in a variety of real estate related assets that provide the company with diversification. While diversification can put a cap on the returns, it also acts to provide sufficient cushion to the book value when the interest rates start climbing.
Two Harbors Investment Corp (NYSE:TWO) is invested in Agency and non-Agency MBS. Besides, it is also invested in commercial MBS and real estate facilities from which rental income comes. While this diversification obviously supports the bottom line and provides a cushion to the book value, Two Harbors Investment Corp (NYSE:TWO) has pursued other strategies to ensure book value preservation.
Two recently announced it is moving into other areas like Prime Jumbo Securitization, credit sensitive loans, mortgage servicing rights and other credit instruments. Expansion into these areas will make Two Harbors Investment Corp (NYSE:TWO) less reliant on the Agency MBS markets, which are facing tremendous volatility due to the Fed’s actions.
Further, Two Harbors Investment Corp (NYSE:TWO) recently announced that it had over $2 billion long to be announced (TBA) positions to over $2 billion short TBA positions during the second quarter of the current year. A TBA position is a forward mortgage backed security trade. An actual MBS is delivered to fulfill a TBA trade. This strategy, coupled with its hedges, is why I feel comfortable that Two Harbors has protected its book value better than most of its peers.
Why not pure-play mREITs?
Among the pure-play mREITs Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are two of the most followed stocks. However, both have seen their stock prices nosedive over the past few months. A primary difference between the hybrids and pure-play mREITs is the composition of their portfolios. The anticipated halt in the Agency MBS purchases by the Fed is causing significant book value depreciation among the Agency mREITs. While the book value of some mREITs is more exposed to changes in interest rates, others have done well to cushion theirs.
The Fed’s anticipated exit has increased volatility in the interest rates. So, higher leverage is the last thing the mREITs want in their capital structure. Higher leverage increases the volatility in the results of mREITs. ARMOUR Residential is leveraged over 9.16 times, one of the highest in the sector. This high leverage is causing significant depreciation in the company’s book value. Further, its recently purchased MBS perform worse when the rates start climbing. In short, ARMOUR was preparing for a prolonged QE, while the Fed has signaled its intentions to exit the Agency markets. Therefore, you can expect book value depreciation of over 12% sequentially.
On the other hand, Annaly Capital Management, Inc. (NYSE:NLY) seems to be well prepared for the Fed’s exit. It has a lower level of leverage (6.7 times) coupled with the presence of commercial real estate (CRE) loans in its portfolio. Both these provide cushion against book value. Besides, the company’s portfolio is structured to benefit from an increasing interest rate environment. To top it off, its recent acquisition of CreXus Investment gives Annaly Capital Management, Inc. (NYSE:NLY) exposure to the commercial MBS market with low double digit returns.
Conclusion
While hybrids are preferred over pure-play mREITs due to the diversification they provide, Two Harbors has implemented other strategies that will create significant benefit for the company in the coming future. This is why it remains my top pick among hybrids. Within the pure-play mREITs, only Annaly Capital Management, Inc. (NYSE:NLY) seems to be prepared for the Fed’s exit.
Adnan Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article Hybrids vs Pure-Play mREITs originally appeared on Fool.com and is written by Adnan Khan.
Adnan is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.
