REITs: Current Yields Make Up for Possible Risk

As the economic situation in the United States appears to be improving, many investors are considering wading right back into the sector that was responsible for tipping the first domino: real-estate. More specifically, securitized mortgages that are sold as investments.

There are several REITs that operate within the space of securitized mortgages. These companies buy the mortgages as investments, or re-securitize them, and sell them and collect a fee. Any individuals who have looked into this sector may have noticed the “fat” yields that some of these equities carry. Notably, Chimera (CIM) with a 16.50% yield; Annaly (NLY) has a current yield of 14.40%; and lastly, American Capital Agency Corp. (AGNC) carries a yield of 19.30%.

It is necessary for yields to be high to entice investors back into a sector that is still very far off from a recovery. Given a stubbornly high unemployment rate, a slow recovering economy, the foreclosure fiasco, and the potential for another wave of ARM resets in 2012, this industry is riddled with risk. However, I believe that it is possible the current yields more than make up for the risk investors face. There have been many articles on Seeking Alpha espousing the merits of all three of these companies (see my article here). This article is to compare these three companies in an environment of rising rates to see which one will perform the best.

So, which company offers the most attractive potential going forward?

Annaly Capital Management

Annaly only invests in relatively risk-free assets that are guaranteed by Fannie Mae (FNMA.OB) and Freddie Mac (FMCC.OB). These agency backed mortgages make up nearly 93% of all of Annaly’s assets. Annaly’s earnings should be relatively stable given their near-guaranteed nature. Annaly uses borrowed money to purchase these mortgage assets. There is one problem: in an environment of rising rates, it will be likely that short term rates are going to rise faster than long terms rates and the yield curve will flatten. This means Annaly’s margins could be squeezed. Annaly’s management team has adopted a policy of using interest rate swaps and other derivatives to manage this interest rate risk to preserve cash-flows, as well as the value of their portfolios. In the event of a 0.75% increase in short-term rates, Annaly’s portfolio income is estimated to decrease 6.78%, and the value of the portfolio is expected to drop 0.84%.

A 6.78% drop in income from current holdings as well as the potential for a decreasing spread on future investments suggests that Annaly’s yield will eventually drop due to increasing rates - that is, unless they can increase leverage ratios to make up the difference. Increasing leverage ratios due to rising interest rates would only be a good idea if accompanied by a healthier economy and a healthier housing market. Also, Annaly is already levered 8.61:1 (they report 6.3:1). This is a high ratio, but given that their income is relatively stable and carries an implicit (and now explicit) government guarantee, that may not necessarily be bad or unsustainable. It does, however, limit how much they can increase leverage ratios to make up for income.

American Capital Agency

American Capital Agency also invests in agency backed mortgages, which make up nearly 95% of all of its assets. Just like Annaly, AGNC uses borrowed money to purchase these mortgages and its future net income is dependent upon the spreads it can receive between short term borrowing and long term rates. AGNC also has the potential to earn money through selling mortgages that it securitized. Demand for these securitizations may be affected by interest rate changes, though it is beyond my ability to determine the scope of such a change.

AGNC estimates a drop in net interest income of 0.8% in the event of rates rising 1.00%. The value of its portfolio is only expected to fall by 1.3%. These fluctuations are less than Annaly’s due in large part to the relative amount of Adjustable Rate Mortgages AGNC owns. These mortgages will pay more when they reset into higher rates (assuming homeowners can afford it). Along with its interest rate hedges, the only foreseeable problem with rising rates is lower margins. Again, increasing leverage could help make up the difference, but this does increase risk and AGNC is already highly levered. By my figures, they are leveraged 11.35:1 (they report 8.5:1).

Chimera

Chimera was spun off from Annaly to separate non-agency securities from Annaly’s portfolio. In short, Annaly manages Chimera’s assets. Chimera invests mainly in non-agency mortgages and CDOs. These come with much higher risks because the income is not guaranteed by government agencies. Chimera tries to manage its risk through being selective in what securities it purchases. Chimera also sells mortgages that it has securitized, diversifying its income a little.

Chimera estimates that a 0.75% increase in interest rates will actually increase its net interest income by 11.46% while reducing its portfolio value 4.29%. Much like AGNC, this is due to the substantial amount of ARMs that Chimera has invested in, as well as the interest rate swaps purchased to hedge interest rate movements. It appears as if Chimera is well positioned to enter into an environment of higher rates with their current holdings. Future margins will be squeezed just like the other two mentioned; however, Chimera has much lower leverage ratios than the other two. By my estimates, Chimera is leveraged 2.49:1 (they report 1.3:1). Clearly, due to the higher risk nature of their investments, Chimera should maintain leverage ratios lower than NLY or AGNC, but, it does appear that in an improving economy Chimera would have some flexibility in increasing its amount of financial leverage to continue paying satisfactory returns.

Of the three REITs listed here, it would appear as if Chimera has the most flexibility going forward and the greatest potential to perform well in an environment of rising rates. It is important to remember, however, that Chimera does so through riskier assets. Personally, Chimera is my favorite, but I do not think investors will go wrong investing in the others either.

Disclosure: I am long CIM. All numbers were taken from, or deduced from, the companies' most recent 10-Qs at the time of publishing. The difference between my reported leverage ratios and those reported by the companies are due to differences in how the leverage was calculated. My formula was the very basic "assets divided by equity" to display a multiple of equity, or, in other words, how much of the company's assets have been financed through debt. The companies' reported numbers come from totaling together liabilities and dividing by equity, giving a multiple of equity for how much debt the company has.