Mortgage REITs Pay Jumbo Dividends, But Watch for Potential Refinancing Wave
Good news for homeowners often spells bad times for home mortgage REITs, and several Joe Public victories lately threaten those 13%-to-20% dividend yields that mortgage REIT investors have grown to love. Are the risks so big now that investors should snub those double-digit offerings?
The latest problem for mortgage REITs involves government-backed refinancing programs for underwater homeowners. They’ve gained steam again, as most states are eager to makes deals that will mitigate their liability for foreclosure abuses. This does nothing for home mortgage investors such as American Capital Agency (AGNC), Annaly Capital (NLY) and Hatteras Financial (HTS), the three biggest companies investing in agency-backed home mortgages. With Freddie Mac and Fannie Mae behind their investments, they have little to lose if some homeowners default anyway. They will, however, lose millions in profits if big numbers of the mortgages they’re holding now are paid off early in favor of new, cheaper loans.
The bigger picture for mREITs is more gruesome. Broadly speaking, the companies make most of their money by borrowing at low interest rates and lending at higher interest rates. So when the spread between those two rates is wide, like it has been in recent years, mREITs tend to roll in the money. That’s one reason their share prices saw very nice gains in 2009.
Since the beginning of the year, short-term interest rates have been going up while long-term interest rates go down. (The chart below shows that trend, rather than actual rates.) REITs work a variety of derivative and hedging schemes to keep cash flowing, but they rarely escape the fact that profits shrink when short and long-term rates get closer.
Perhaps the biggest threat to REITs is the potential for a drying-up of the short-term funding necessary for them to continue business as usual. We got a whiff of such a scenario on several occasions last year when worries about the European debt crisis caused U.S. banks to tighten their wallets. REIT prices dropped as much as 15%.
And just as the companies were coming to grips with this new reality, the Securities and Exchange Commission began to question whether the government should be granting these entities the special tax status that makes them thrive. At issue, and now in public comment stage, is the leveraged status mortgage REITs typically maintain.
Several REITs, including American Capital and Annaly, have already cut dividends in anticipation of harder times ahead. But yields in the sector still remain among the highest in the market – American Capital will be close to 17% even after the cut, and Annaly and Hatteras are still at around 13%.
With total 5-year returns for these companies ranging from about 70% to 200%, YCharts Pro considers all three of them undervalued now and gives each of them strong ratings for fundamentals. And despite the obstacles ahead, analysts are still quite gung ho for American Capital, the middle in size of the three with a market cap of $5.3 billion. Several major investment firms, including Morgan Stanley and Barclays Capital, started coverage of American Capital with overweight ratings recently. Annaly and Hatteras are decorated largely with hold ratings.
Despite the kudos, few expect high REIT payouts to continue for long. Government-backing against loan defaults adds an element of safety to these kinds of REITs, but it doesn’t protect against everything that might hit profits and lower payouts. Then again, real safety, in the form of 10-year-Treasuries, is paying about 1.86%.