The success of mortgage REITs in the past has largely been the result of an unhedged (unprotected) portfolio completely exposed to the vicissitudes of interest rates. Mortgage market dynamics are inherently difficult to predict, and most mortgage REITs can only bolster economic returns as measured through gross ROEs via adding additional leverage. Spread income has always been a less-material driver to book value than other comprehensive losses, or when unrealized losses on a mortgage REIT’s investments are marked to market.
Very few analysts have the ability to effectively analyze these complex instruments, and while we’ve been correct about the risks related to their investment opportunities, we continue to believe it is borderline irresponsible for financial advisors to be using mortgage REITs in income portfolios. The reward does not match the risk. It’s simply not worth losing 20% of one’s capital for a 5%-10% annual dividend payment, which may or may not be cut in the future. Watch Valuentum’s Brian Nelson highlight three important concepts of dividends in this video here.
In American Capital Agency’s (AGNC) third-quarter report, the firm put up a comprehensive loss per share and ended the period with a net book value per share of $25.54 (down 2.7% from the $26.26 mark at the end of June). The firm’s internal measure of economic return for the period was -1.1% on an annualized basis, below the high-single-digit hurdle rate we generally require to like a firm’s business model. Said differently, American Capital destroyed shareholder value this quarter. The ($0.07) comprehensive loss per share was overwhelmingly driven by other comprehensive losses, which include net unrealized losses on investments marked to market through other comprehensive income (OCI).
The situation where OCI losses overwhelm spread net income has become all-too common for mortgage REITs, and unless these entities are unhedged in a favorable market environment, book value growth is exceedingly difficult to come by, especially when it is constantly diluted by dividend payments. The company paid a quarterly dividend of $0.65 per share, which is an ~11% payout on an annualized basis. Clearly, the high dividend is more a reflection of the firm’s incredibly risky business model than management’s shareholder friendliness.
American Capital Agency’s “at-risk” leverage of 6.7 times is far too high for us to be interested in putting hard-earned capital to work in shares, but we think its technicals are worth paying attention to – if shares break through $24.50 per share to the upside, it could represent a key read on the mortgage and Treasury markets. Still, on a fundamental basis, there are few companies that have a riskier business model. Caveat emptor.
Related Firms: ACC, NLY, AIV, AMTG, ARR, AEC, AVB, CPT, CCG, CYS, EDR, ELS, EQR, ESS, HTS, HME, MAA, NYMT, PMT, PPS, SNH, SUI, TWO, UDR.