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Exponential Growth at Agency mREITs Brings Them Under Regulatory Microscope

Saturday - 4/6/2013, 9:25pm  ET

How Do REITs Make Money?

Mortgage REITs invest in commercial/residential mortgage backed securities and earn a spread between their asset yields and the cost of funds. The mortgage backed securities in which mREITs are invested are their assets and they yield interest. They use short-term financing to purchase these assets and pay cost of funds on their borrowings. The primary objective of mortgage REITs is to provide its investors elevated returns, largely in the form of a dividend yield. Part of the return is composed of the stock price appreciation. Further, mortgage REITs are required to pay out 90% of their core income in the form of dividends. This payout allows them to be taxed at a preferential rate. Therefore, the high payout and the resultant elevated returns have made them a lucrative investment opportunity in the United States, particularly when the government has forced interest rates to remain at their lowest.

Impact of Government’s Easing

Agency mortgage RIETs were hurt badly when the Fed launched its third round of easing, better known as QE3. The easing was aimed at purchasing $40 billion in Agency mortgage backed securities each month with the objective of bringing down the mortgage rates. While the stock market has appreciated the move in general, the spreads at Agency mortgage REITs were compressed, causing dividend cuts.

The net interest rate spread for Annaly Capital Management at the end of the third quarter of the prior year came in at 1.02%, down 52 bps from the second quarter’s net interest rate spread. The second quarter spread was down 17 bps from the linked quarter’s spread. This forced Annaly Capital to cut its dividend rate twice during the prior year.

Similarly, asset yields at American Capital Agency decreased from an average of 3.19% during 2011 to 2.82% during 2012. However, the average cost of funds increased 11 bps to 1.11% over the same time period. This caused the net interest rate spread of American Capital Agency to decrease 48 bps over the prior year. However, the company was able to maintain its quarterly dividend rate, largely due to record low prepayment rates.

The third quarter net interest rate spread for Armour Residential REIT was 1.82%, down 33 bps from the linked quarter’s spread. Similarly, the second quarter spread of 2.15% was down 8 bps from the first quarter’s net interest rate spread, causing the company to cut its monthly dividends twice during 2012.

CYS Investments is another Agency mortgage REIT. It reported a third quarter net interest rate spread of 1.24%, down 47 bps from the linked quarter’s spread. The company slashed its dividend once during the prior year. Therefore, it is visible that the quantitative easing had a negative impact of the pure-play mortgage REITs.

Exponential Expansion In

After QE3 came in action last year, many mortgage RIETs, particularly the ones invested in Agency residential mortgage backed securities, faced pressure as far as their net interest rate spreads were concerned. Still, mortgage REITs were leading the REIT market in performance with an 18% gain in the first quarter of the current year. The entire REIT sector is considered to have faced little trouble raising capital. Around $19 billion was raised during the fourth quarter of the prior year, while another $23 billion has already been raised since the beginning of the current year, according to NAREIT. REITs bought over $100 billion of Agency backed mortgage backed securities in 2012. This is the highest since the financial meltdown of 2008. According to Bloomberg, Agency mortgage REITs are expected to purchase another $60 billion worth of securities this year.

American Capital Agency announced a public offering of its 50 million common shares in February this year. This is followed by Armour Residential’s announcement of 65 million common shares being offered in a public offering.

No Primary Regulator

This exponential expansion during such challenging times has caused Fed Governor Jeremy Stein to voice concern. REITs have $400 billion of debt on their balance sheets, which is a risky behavior, he said. Therefore, he believes pure-play mortgage REITs require regulator attention before they explode in size. However, unlike insurers and banks, mortgage REITs do not have a primary regulator yet, which is why there are not subjected to any restrictions as far as their leverage is concerned.

American Capital Agency, Annaly Capital Management, Armour Residential and CYS Investment employ 7 times, 6.6 times 8 times and 7.7 times, respectively.


It is widely accepted that Agency mortgage REITs provided elevated returns in the form of dividends. However, these elevated returns are not without risks. The associated risks are high and you need to be cautious when investing in mortgage REITs. Additionally, because mortgage REITs do not have a primary regulator, you need to be more cautious.

This article was originally published as Exponential Growth at Agency mREITs Brings Them Under Regulatory Microscopeon

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