A Safer Way to Invest in mREITs

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Many mortgage Real Estate Investment Trusts (mREITs) have taken significant hits over the past five months -- share values have tanked, and dividends have been cut.

Let's look at one way to invest in this beaten-down sector with less risk than simply buying the common shares. 

How? Buy select preferred stock securities instead of the common.

General mREIT investment thesis
Before going further, we need an investment thesis to determine if mREITs are worth purchasing at all. The recent spike in long interest rates, related market fears of a sustained rise in rates, and very negative investor sentiment portend that mREITs may continue to experience near-term headwinds and volatility.  

However, seasoned investors may see opportunity amid current fears.

Here are three reasons well-managed mREITs may be good long-term investments.

First, the widening spread
mREITs make money on the "spread," or the differential between short-term and long-term interest rates. Management borrows funds on the short end of the yield curve, then purchases longer duration MBS (mortgage backed securities), thereby pocketing the spread. For much of 2013, mREITs have battled a narrowing spread. This appears to be changing; the 2-10 year spread has widened considerably since May.

The above graph highlights the yield spread between Treasury 10-year and 2-year notes over the past 15 years. The Fed's talk of tapering has created a considerable jump in the differential. However, one can see that the current spread is not excessive by historic standards.

A widening spread should ultimately translate into higher net interest income and, presumably, higher mREIT dividends.

Second, the worst may be over
Much of the pain in mREITs has been associated with an unprecedented, rapid rise in long-term rates. Between May and September of this year, rates on the 30-year Treasury bond spiked over 100 basis points. This shift pressured mREITs to write down book asset values in accordance with mark-to-market rules. Indeed, as rates rise, the value of existing MBS paper declines. The probability of continued steeply escalating interest rates may be fairly low: Neither the Fed nor Washington politicians want this to happen.

Yields on 30-year Treasuries (TYX) versus T-Bills (IRX) -- year to date:

Notice how long rates (the yellow line) have ramped up, short rates (the blue line) have remained anchored near zero.

Third, mREITs have a defense
mREITs have several tools in their arsenals to mitigate rising rates and narrow spreads.

  • Leverage
  • Hedges and swaps
  • Diversification

Indeed, some investors mistakenly believe that mREITs are completely at the mercy of higher interest rates. They are not. 

Leverage permits management to draw upon readily available borrowed funds in order to invest more money at better spreads without liquidating existing assets at a loss.

Hedges and swaps allow mREITs to buffer interest rate changes. While it's nearly impossible to fully hedge positions, well-placed hedges and swaps can pay off when interest rates rise, thereby protecting book value or net interest income.

Diversification may provide a "back door" during periods when the MBS market faces hard times. For example, one major mREIT recently acquired a commercial real estate trust.  This acquisition offers the parent company a related but alternate source of cash flow that isn't tied to the bread-and-butter MBS business. 

How can mREIT preferred shares be safer than common stock?
Preferred stock can be a safer, yet quite attractive alternative to common stock ownership under certain circumstances:

  • The preferred security may be purchased below par value.
  • The dividend yield is attractive.
  • The preferred stock has cumulative dividend rights.
  • An investor is confident the underlying company will remain solvent.

Preferred stock is typically issued at par value; this is also the lowest price upon which the shares may be called by the issuer. The concept is similar to a bond. If one buys a preferred security below par, he knows that even though it may be called away, capital appreciation is built into the action.  

Mortgage REIT preferred securities have outstanding dividend yields. Most yield over 7%.

All preferred stock ranks ahead of common shares for dividend payment. This means no dividends may be paid on common shares unless the preferred dividends are paid first. Cumulative dividend rights mean that not only are dividends paid first, but in the event of suspended dividends on both common and preferred shares, the preferred stockholders must be paid all the back dividends before any dividends can be paid to the common shareholders.

Therefore, as long as an investor believes the mREIT will remain a viable enterprise, he will ultimately receive full payment of all dividends. Common shareholders have no such assurance.

Which issues may be attractive?
The following table provides preferred shares information issued by these underlying mREITs:

  • Annaly Capital Management
  • American Capital Agency
  • Invesco Mortgage Capital

The specific preferred securities referenced above are:

  • Annaly Capital Management Series D Preferred Stock
  • American Capital Agency Series A Preferred Stock
  • Invesco Mortgage Capital Series A Preferred Stock

These three issues all offer cumulative dividend rights and juicy dividends. However, while the par values are all $25, the current market price varies.

Annaly Capital Series D preferred trades at a 6.9% discount to par, and Invesco Series A has an even wider 11% gap. On the other hand, the American Capital preferred shares trade at a slight premium to par.

Therefore, the Annaly and Invesco securities appear to offer a better combination of high yield, cumulative dividends, and current market prices below par value. While the Invesco shares stretch for yield, Annaly Capital is by far the largest, oldest and most established of the mREITs. The company has a long history of astute, conservative management.

Bottom line
Investors seeking exposure to the beaten-down mREIT sector may find preferred stock a safer, yet quite profitable way to play the sector versus common shares. In exchange for accepting approximately 4% less yield than the common stock, preferred stockholders have the security of knowing that the dividend is fixed, paid ahead of any common stock dividends, and cumulative. 

Furthermore, recent sector worries now provide an entry point below the stated par value, thereby affording shareholders the potential for upside capital appreciation.

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The article A Safer Way to Invest in mREITs originally appeared on Fool.com.

Raymond Merola owns Annaly Capital Management Series D Preferred Stock. Please do your own careful due diligence before making any investment. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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