I saw some interesting trends in the results reported by Capstead Mortgage (CMO) after Wednesday's close. It's easy to lose individual companies within the flood of earnings results, but mortgage REITs have been red-hot this year, and CMO's results show why.
The company showed a 3.8% sequential increase in net income for the first quarter of 2014 and the "internals" (the factors driving earnings growth) were all positive sequentially:
- Financing spreads rose 5 basis points to 1.30%.
- Prepayment speeds continued to slow as CMO's constant prepayment rate slowed to 15.16%, a rate which was down 12% from the fourth quarter of 2013.
- CMO's average repo rate fell 6 basis points to 0.32%.
- All of this allowed CMO's Board to raise the quarterly dividend 10% to $0.34 per common share.
CMO is not a perfect bellwether for the mortgage REIT world because they invest mainly in ARMs. But, when interest rates vary so little, that becomes less of a distinction. Remember that every Chicken Little who was yelling "leverage is going to kill the MREITs" last summer was forgetting that leverage works both ways. Hence, CMO can turn a 3.7% increase in net income into a 10% increase in the dividend.
The market gets it -- as evidenced by the sizzling performance of the REIT sector in the first four months of 2014. "Sizzling" almost seems like a typo to someone who remembers Bernanke's ham-handed May 2013 "taper" speech and the resulting panic it caused in REIT-Land, especially among mortgage REITs.
But that's the past. In 2014, REITs have outperformed markedly, especially mREITs. As of Tuesday's close (the numbers are calculated with a one-day lag) the FTSE NAREIT index had posted a total price appreciation of 9.85% this year vs. The S&P's increase of 2.25%.
Total return is always a better measure for REITs, given their high-dividend policies (REITs have to distribute at least 90% of FFOs to maintain tax-free status.) On that measure the returns are even more impressive with the NAREIT index as a whole posting an 11.29% gain thus far in 2014 and the residential mortgage REIT sub-index posting a huge 13.95% gain.
The slowdown in mortgage refinancing has been a boon for the mREITs and CMO's CEO Andrew Jacobs noted that the lower repo rates seen in the first quarter have continued in April. Thus, the two main factors driving costs for REITs (given constant leverage) are heading in the right direction.
In terms of investment favorability, there's only one macro issue that could counter those micro improvements -- yes, the dreaded Treasury note backup. Before Wednesday's FOMC meeting statement, the yield on the 10-year sat at 2.65%, a decline of 39 basis points thus far in 2014.
Thus, every pundit who called for a back-up in rates through 3% in early-2014 with an eye towards 4% was dead wrong. Interestingly, I continue to read predictions of a coming Treasury correction, and, honestly, most of them are coming from the same pundits. Again, they will be proven wrong.
The U.S. economy is just not as strong as the Treasury bears would have you believe, and Wednesday's shocking 0.1% print for U.S. first quarter 2014 GDP had to be a punch in the chops for those cheerleaders. Yes, the economy will be stronger in the second quarter than it was in the first quarter as weather factors neutralize. But that's more of a reversion to mean than an acceleration in growth.
Bottom line: Treasury yields will remain low and the relative attractiveness of REIT dividends will continue to drive strong performance in the group. Add to that the potential for increases in absolute REIT dividend payouts owing to lower refi and repo rates. Then you have a group that should be finding your investment dollars, especially if income is important to you.