A Clear-Cut Case for mREITs

 | Aug 26, 2012 | 5:30 PM EDT  | Comments
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wmc

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mtge

In contemplating why income investors buy mortgage real estate investment trusts (mREITs), I've concluded -- based on my Occam's Razor suppositions -- that it's for the 10%-plus dividend yields. When applied here, the theory requires investors to make as few assumptions as practical, and I here present two assumptions that support investment in mREITs.

Assumption 1: The U.S. Dollar Will Remain a Safe Haven.

Sovereign credit default swap valuations highlight the ongoing European currency situation: Spain and Italy's markets possess a material currency risk. The U.S., on the other hand, has low currency risk.

Sovereign Default Credit Swaps

As a result, smart money will continue to flow from these high-risk markets to the safer U.S. After all, Germany can't save Europe entirely from the currency crisis. For a Spain currency holder, doing nothing in itself carries the risk of currency devaluation.

Implied U.S. Federal Guarantee: Agency mREITs own mortgage-backed securities (MBS), a government-sponsored enterprise, meaning these mREITs own assets with an implicit guarantee from the U.S. government.

The Best Agency mREIT Value: My pick here is the Legg Mason (LM)-managed Western Asset Mortgage Capital (WMC), which went public on May 11. In the second quarter, Western Asset Mortgage paid a stub dividend of $0.38, equaling to a $3 annual dividend -- that is, a 14.3% annual yield.

American Capital Agency, American Capital Mortgage, Western Asset Mortgage Data

In addition, Western Asset Mortgage trades at a 3.72% premium to its June 30 book value. The mREIT business model is, in essence, a leveraged bond fund with interest rate hedges -- and this firm leverages its fund by an 8.3x multiple.

American Capital Mortgage (MTGE), my other top mREIT pick, trades at a 16% premium to book value. Gary Kain, president and chief investment officer of ACM and American Capital Agency (AGNC) -- both of which are run by American Capital (ACAS) -- has proven he's capable of generating significant mREIT returns. Management is crucial.

Americal Capital Agency (AGNC) vs. Annaly Capital Management (NLY)

Assumption 2: U.S. Housing Sector Further Stabilize

The U.S. housing market is stabilizing, and hybrid mREITs have been beneficiaries. Hybrid mREITs buy agency MBS and non-agency MBS, the latter of which does not offer the implied government guarantee. The non-agency paper can trade at significant discounts to the MBS face value.

My favorite hybrid mREIT is the above-mentioned American Capital Mortgage, which began trading publicly in August 2011.

American Capital Mortgage (MTGE) -- Total Return

ACM has returned 50.24% since the initial public offering, which is impressive. I also like this company due to its smaller market capitalization. Moreover, management can be nimble, given that they deal in both agency and non-agency MBS. The company is also currently paying a 14.8% dividend; even if it's cut to $0.80, the annual yield would be a credible 13.2%. Finally, the book value per share establishes a quantitative mREIT balance-sheet valuation.

Actions Backed by Assumptions

Again, I assume the European currency crisis will remain for an indefinite time frame, so the U.S. Treasury bond market should trade at historic lows thanks to the flight to the safe-haven U.S. Dollar.

I also assume the U.S. housing market will continue to stabilize. So non-agency MBS, if purchased selectively, should increase in value and benefit hybrid mREITs such as American Capital Mortgage.

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