As I mentioned in this earlier post I think there is an good investment opportunity in mortgage REITs (mREITs from now on). Its one of the the few remaining relatively undervalued sectors in the market and offers a compelling dividend yield of about 16%. In this post I’ll provide a basic economic framework to evaluate REITs and provide valuations for the big cap (>$1B) MLP names I’ll be covering.
In my first post on mREITs I described how the companies in this sector make money. Basically, the companies leverage up their equity and invest the funds in mortgage backed securities. The difference between what the mortgage investments yield and what they pay to borrow money determines their returns. Pretty simple. Of course, the devil is in the details. In the table below, I present a simple model for mortgage REIT economics using data for the large cap mREITs. Data is as of the quarter ending March 31, 2011. The companies in this table all have differences in their business model but the basic economics are the same. For example. NLY focuses exclusively in Agency mortgages, CIM primarily non-agency mortgages, and IVR does a little of both.
Lets walk through NLY to illustrate the model. The first line shows that NLY owns a portfolio of mortgages that yields 3.79%. The amount it costs for NLY to borrow money is shown on the second line, a cost of funds of 1.62%. This cost of funds line is net of any hedges the company may have. The difference between the portfolio’s yield and what it cost them to borrow is how much money they make before expenses, their net interest margin. 2.17% in NLY’s case. This is like the gross margin line for a typical corporation. The net interest margin is then multiplied by how much leverage they have (6.3 for NLY), i.e. how much money they’ve borrowed relative to their equity, and added to the yield on their equity to arrive at a gross ROE (return on equity), 17.46% for NLY. Then overall corporate expenses are subtracted to arrive at a net core ROE of 16.11% for NLY. The core ROE number is critical because it basically determined the dividend paying capacity for the mREIT. In general, you want core ROE percentages to be the same or higher than the dividend yield. Notice that this is the case for all the mREITs except CYS.
Most of the REITs in the table report core ROE which is different from GAAP ROE. Core ROE or core earnings are meant to represent the dividend paying capacity of the company. Items such as one time gains from the sale of mortgage securities go into GAAP ROE which may not be representative of the on-going dividends the firm can pay. Basically, pay attention to core ROE and look for it to be at or above the dividend yield of the stock. By sticking to this rule of thumb its hard to go wrong. If there is a quarter where the core ROE falls below the dividend yield then its time to look into the details. For example, for CYS in the table above the core ROE is 10.4% but their dividend yield is 19%. Not a good sign in the face of it. But diving into the details you find that CYS carries a bunch of MBS forwards (a type of hedge) on their books that impacts their core ROE but not their dividend paying capacity.
In today’s environment of low short term interest rates mREITs are making good money. The net interest margins in the table above are pretty high relative to history. Also, because of these large margins the mREITs have been able to keep their leverage ratios low. For example, in the past, NLY has run leverage ratios of between 8 and 12. It looks like the good money making conditions will persist until the end of 2012 at least according to most analysts. When net interest margins begin to decline mREITs will be able to increase leverage ratios to maintain good returns.
What is happening now is that there is some fear in the market that mREIT margins will decline as interest rates increase and thus their dividend yields will decrease. For this reason mREITs continue to trade at reasonable valuations. If and when interest rates begin to rise mREITs have a few tools at their disposal to mitigate the impact. One, the low leverage rations give them room to increase leverage as interest margins decline. Second, most REITs hedge a portion of any potential interest rate impact, especially on their cost of funds, through interest rate swaps. And when this does start to happen an investor will be able to see it by monitoring the parameters I listed in the economic model. History has shown that an investor can see these big impacts coming way before they impact the stock price in a big way.
Finally, in the table below I show the big cap mREITs, their dividends, dividend yields, stock price as of last Friday and their valuations. Price to book is my favorite valuation metric for mREITs. Normally, price to book levels of 1.1 have proven to be good entry points but each stock is slightly different and you should do your own research.
In summary, I think mREITs represent decent value in today’s market. A lid is being kept on valuations due to the fear of imminent large rises in interest rates. These fears are overblown and underestimate the tools the mREITS have to mitigate the impact of rising rates. An average dividend yield of 16% for this group of mREITs is an attractive risk reward tradeoff.
Disclosure: Long CIM, NLY