This mREIT is a Cut Above The Rest
In the midst of a westernized version of Japan’s ‘lost decade’, in which stagnant growth has plagued the U.S. economy despite the Fed’s rock-bottom interest rate policy, investors are desperate for an asset that provides abnormal yet consistent returns. Mortgage Real Estate Investment Trusts, which invest in residential real estate and give 90 percent of their profits to investors, have historically proven to be reliable investments.
Known as mREITs for short, these organizations acquire capital by either: (1) selling stock to investors through a process known as a secondary offering, or (2) borrowing at short-term interest rates. Consequently, an mREIT uses this capital to purchase mortgage-backed securities, which are pools of mortgage loans packaged into tradable assets. These MBS pay a higher return than short-term interest rates, which is how an mREIT makes its money. A form of price arbitrage, the higher the spread is between these two rates, the greater the mREIT’s profit. Going further, there are two distinct classifications that mREITs fall into: non-agency and agency trusts. The latter invest in mortgages that are insured by federal mortgagors Fannie Mae, Freddie Mac, or Ginnie Mae, and provide the safest return to investors. Currently, one of the most attractive agency mREITs looks to be American Capital Agency (NASDAQ: AGNC) based on the following reasons.
1. A small percentage of American Capital’s mortgages are at maturity. In the early years of a low interest rate environment, mREITs are considered to be bullish investments, as the spread between short-term interest rates and tradable MBS is higher than normal. When lower rates persist, however, this spread eventually normalizes, as higher-yielding MBS mature and mREITs are forced to reinvest in lower-yielding mortgages. We can measure the percentage of maturing mortgages in an mREIT’s portfolio through the constant prepayment rate (CPR), which is reported to the SEC each quarter.
Since the Fed has maintained that interest rates will remain low through 2014, investors want an mREIT with a low CPR, as this would signify it would not be forced to reinvest in as many lower-yielding mortgages. Currently, American Capital has a CPR of 12 percent, which is lower than competitors like Annaly Capital Management (NYSE: NLY) at 19 percent, Anworth Mortgage Asset (NYSE: ANH) at 22 percent, Capstead Mortgage Corp (NYSE: CMO) at 14.5 percent, and Hatteras Financial (NYSE: HTS) at 25.7 percent. Moreover, this at least partially explains the yield advantage that American Capital has with regards to its competitors. Specifically, AGNC pays a dividend yield of 15.3 percent, which is higher than NLY (13.1%), ANH (12.4%), CMO (12.2%), and HTS (12.4%).
2. American Capital has been growing faster than its competitors. It’s also important for investors to look at the Funds from Operations (FFO) of mREITs, which is essentially a measure of net income excluding depreciation and property value fluctuations. In the mREIT world, FFO is the best way to determine a trust’s ability to maintain its dividend payments in the future. It is a more commonly used gauge of performance than earnings, and also renders the P/E ratio useless – more on that shortly. With a trailing twelve month FFO of $2.4 billion, American Capital trails Annaly Capital ($3.6 billion) in size, but is in better shape than its other primary competitors. Upon further inspection, AGNC looks like the best of the bunch when growth is factored into the equation. Since its inception in 2008, AGNC has grown its FFO by a stratospheric 1,128 percent a year, which is oodles higher than NLY (21.8%), ANH (16.8%), CMO (8.6%), and HTS (64.8%).
3. From a valuation standpoint, shares of AGNC are underpriced. As mentioned above, the P/E ratio is useless to compare American Capital with its competitors. Instead, a Price-to-FFO ratio must be used, which shows how investors are valuing an mREIT’s Funds from Operations. Interestingly, AGNC has a P/FFO ratio of 2.5X, which is lower than competitors NLY (4.3X), ANH (2.6X), and CMO (2.6X), and on par with HTS. In fact, American Capital also offers investors the highest FFO per share, with $12.97, which is greater than NLY ($3.91), ANH ($2.70), CMO ($5.58), and HTS ($11.89).
Looking ahead, American Capital still faces the risks that other mREITs do – primarily from interest rate fluctuations and federal stimulus programs like HARP. Perhaps Fool analyst Alex Dumortier said it best when he warned that mREIT dividends are not “free money”, though the points mentioned above should at least give investors confidence to invest in AGNC over its competitors. Whether it’s this mREIT’s attractive mortgage portfolio, strong FFO growth, or undervaluation, American Capital is in the best position to maintain its top-tier yield with solid price appreciation going forward. WealthLift’s Sentiment Index also rates AGNC as a strong buy, with nearly 100 percent of investors placing an overperform rating on the mREIT over the next year.
Disclosure: The author has no holdings in the stocks mentioned in this article and has no plans to initiate any positions within the next 72 hours. He does, however, have the intention of rating these stocks on WealthLift.com, a social media website where investment ideas are shared openly and free.
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