I get asked a lot about investing in mortgage REITs. Investors are being “pitched” these mREITs as conservative “income” investments with yields of 10-15%. They seem like a safe bet, as “you would need Fannie / Freddie to go under for them not to work out”.

Sound too good to be true? Yup. That’s because it is.

(The most common questions I get are on NLY (the largest mREIT) so numbers in this post will be NLY’s, unless stated otherwise. NLY invests in guaranteed agency mortgages.)

I discussed in my post “Make sure you GET PAID!“, that you should focus on Risk & Reward when making an investment. Ideally you want the upside to be meaningfully greater than the downside (hence the appeal of options & other derivative investments). An investment should have asymmetric returns… but make sure the asymmetry is to the upside!

I DO think that mREITs returns are asymmetric, but IMO the asymmetry is to the downside! You have a max upside of the dividend, maybe another 5-10% on top of that, but i think the downside potential is 50+%.

Let’s first look at the upside. If almost every time NLY goes above their NAV, they issue more shares and dilute existing shareholders, how do you expect to make additional upside via capital appreciation? Of course it makes sense for them to issue more shares, that’s their business model. They want to grow their company, invest in more mortgages that they think will enhance shareholder value. But if every time you have a secondary offering, you “have” to offer it at a discount and existing shareholders get diluted, it won’t help you on the capital gains front.

How about downside risks? Well, there’s Interest rates, Liquidity, Credit (for non-agency mREITs like CIM) Prepayment, and many more. (You can read pages 17 thru 34 on NLY’s 10-K – yes, that’s 17 pages of risk disclosures!)

I think it’s fair to say, the largest risk is Interest Rates increasing. Yes, rates are expected to stay low for the foreseeable future, but not forever.

Let’s talk a bit about the mREIT business model. They borrow money at short term rates (currently at around 1.5%) and invest that money in longer duration MBSs, yielding (they hope) higher amounts (currently around 3.5%). The difference between the Cost of the borrowing and the Interest on the investments is the “Spread”. On top of earning the spread, mREITs use leverage (currently 5-10X) to magnify the returns. So while the actual spread is around 2%, if they lever that up 5x – they can have a ROE of >10%.

There are two major issues for mREITs when interest rates rise. (Keep in mind, when rates rise, short term rates typically rise faster than long term rates.)

1. Their funding costs go up (faster than the increase of their interest income), causing lower ROE, lower earnings, and hence lower dividends.
2. Their existing portfolio of securities goes down in value. This causes their stated Book Value to fall.

Don’t take my word for it.  Look at what happened to the group in 2003-05 (the last real interest rate increase cycle). The average yield on mREITs went from 15% down to 4%! Book Values & stock prices collapsed.

Look at what happened last July when overnight repos jumped 9 basis points (due to US credit downgrade fears). On an average, mREITs fell by over 10% the next day (before rebounding). (NLY at one point was down as much as 18%!)

Let’s look at actual figures. In 2011 – NLY had $96.7M in Interest-Earning Assets yielding 3.70% on average, but because of historically low interest rates, their $84.6M of Interest-Bearing Liabilities cost only 1.61% for a spread of 2.09%. They ended 2011 with leverage of 5.4/1 (which is low vs their stated 8-12x target). If you use that leverage ratio you’ll get a ending 2011 ROE of 13.38.

How about in a different environment? Let’s look at 2007. NLY had $40.8M in Interest-Earning Assets yielding 5.77%, while they had $38M Interest-Bearing Liabilities costing 5.07%. Their spread was only.70%! Using that same 5.4/1 leverage, ROE shrinks to only 4.48 or about a third of the 2011 figure! All else equal, a return to that environment would shrink earnings, and the dividend by a third.

Yes, there are hedges that these companies put on.
My answer to that, one symbol: JPM.

- MicroFundy