Lifting the Veil on mREITs

 | Jun 04, 2013 | 9:00 AM EDT
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I believe this week will be a tipping point for shares of mortgage real estate investment trusts (mREITs). "Out of favor" doesn't even begin to do this sector justice, and mREIT stocks fell again Monday, even as mortgage-backed securities and U.S. Treasury bond prices emerged little changed on the day.

It's time for the mREIT management teams to tell their side of the story, and two conferences in New York this week will give them that opportunity. Keefe, Bruyette & Woods is set to hold its mortgage-finance gathering Tuesday, and several mREITs are presenting on Wednesday at Deutsche Bank's dbaccess conference, which is due to host presentations from a broader group of financial companies.

The lineup for the KBW conference even includes Armour Residential REIT (ARR), a holding at my Portfolio Guru firm. Armour is the Greta Garbo of financial-management teams, and these guys do not emerge often. So the fact that they released their presentation several days early, and commented in a Bloomberg BusinessWeek story last week, shows that they've been motivated to lift the veil. A 22% share decline (year to date) in a buoyant overall market tends to have that effect on a management team.

So what do executives at Armour and the other mREITs need to say to reassure the Street? These three key questions need to be answered by each.

1. Explain the nexus between two competing forces. On the one hand are higher mortgage rates and lower MBS pricing, which pressure book value. On the other are slower prepayment rates, which support earnings per share and dividend payouts. I can write a million words on the importance of the dividend-payout rate to mREIT fair values and, conversely, the low import of transitory asset-prices changes to long-term fair value.

But what I say isn't crucial. What is important are the following two points. First, mREIT management teams need to understand that dividend payouts should be maintained at or near current levels due to less pressure from prepayment amortization -- and they need to explain that not-inconsequential point to analysts. Second, they must explain the market forces causing MBS prices to gyrate, and delineate how those gyrations affect book value.

2. Debunk the Fed myth. There is a strong suspicion in the markets that the end of the third and fourth rounds of quantitative easing -- the Federal Reserve's bond-buying regime -- will bring an end to mREIT profitability. I believe that's a gross overreaction. But, again, it's up to the CEOs to explain how the Fed is currently affecting their market and how the tapering (or cessation) of QE4 will affect mREIT balance sheets and earnings.

It may not be a pleasant scenario, but it is one that needs to be addressed. The rigor of management's reactive plan to a "worst-case scenario" -- i.e. if the Fed stops buying tomorrow -- needs to impress investors if they are to continue holding shares in the sector.

3. Commit to returning cash to shareholders. Each management team can do this individually but, remember, this is an industry that issued a massive amount of common and preferred equity between the first quarter of 2012 and that of this year. Investors need to be convinced that mREIT management teams -- all of whom are compensated based on capital raised -- have the faith in their business models to buy back stock when valuations fall materially below book value. Those valuations certainly are at that point this week.

Any finance textbook would indicate that, when a company buys back shares below book value, it's accretive to that very book value. These management teams were quite eager to "sell high" and raise capital when the market outlook was sanguine on the mREITs, and it is absolutely imperative that they prove they are willing to "buy low" and purchase/retire shares now.

The table below shows the conference schedule for several leading mREITs.

Source: Portfolio Guru

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