The past year has been terrible for the mortgage industry. Mortgage originators have seen volumes dwindle as rising rates have eliminated the incentive to refinance, and homebuyers have seen a significant decline in home affordability. Mortgage real estate investment trusts (mREITs) have struggled as well, amid rising rates and concern as Federal Reserve reduces it holding of debt securities have caused mortgage-backed securities to underperform Treasuries. As a result, a lot of mREITs are trading with dividend yields in the midteens after their shares plunged. Annaly Capital (NLY -0.70%) is a leading mREITs, with a dividend yield of 16.1%. Why is that?
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Mortgage REITs are a different animal
Mortgage REITs are complicated stocks, a bit different from typical real estate investment trusts. Most REITs earn their returns by developing properties and then leasing them out . These properties could be shopping malls, office towers, or apartment buildings. Mortgage REITs don't buy real estate, however; they buy real estate debt. These companies will build a portfolio of mortgage-backed securities or whole loans and then use borrowed money (i.e., leverage) to turn a portfolio of mortgage-backed securities paying 4% into a dividend yield of 16%.
Annaly Capital is different from its biggest rival, AGNC Investment (AGNC -0.32%). AGNC Investment builds its portfolio almost exclusively out of mortgage-backed securities that are guaranteed by the U.S. government. If you had a mortgage guaranteed by the government-sponsored entities Fannie Mae (FNMA 9.45%) or Freddie Mac (FMCC 12.27%), chances are your mortgage was put into a security, which might have ended up on Annaly's balance sheet.
Although Annaly Capital has a portfolio of agency securities, which means they are guaranteed by the government, it also has a residential credit portfolio. The residential credit portfolio is made of loans not guaranteed by the government. These loans entail credit risk, but generally pay higher rates.
Mortgage servicing rights have outperformed this year
Annaly also has a portfolio of mortgage servicing rights, which are a very unusual asset. A mortgage servicer performs the administrative tasks of managing the mortgage on behalf of the investor. In compensation, the servicer gets paid a fee of 0.25% of the outstanding principal balance of the mortgage. So for a $400,000 mortgage, Annaly gets paid $1,000 per year. The right to perform that service is worth something, and it is capitalized on the balance sheet as an asset. Mortgage servicing rights are among the few assets that increase in value as interest rates rise, and they have been the engine for returns this year.
Annaly's portfolio is meant to perform in all interest rate environments. In a recession, rates should fall, which will help the mortgage securities portfolio. In a boom, the residential credit portfolio will outperform, and if interest rates rise, mortgage servicing will pick up the load.
A lot will depend on the Fed
Mortgage REITs have been hit hard as mortgage-backed securities have underperformed this year. Part of the issue has been the fear that the Fed will sell off the enormous portfolio of mortgage-backed securities it bought during the quantitative easing days. This has been a cloud over the whole sector and has resulted in declines in book value per share as these securities have underperformed their interest rate hedges.
These declines in book value have not been the result of sales, which means the losses have not been realized. If mortgage-backed security spreads return to historical levels, these losses in book value should be recouped. Investors who buy Annaly are betting that mortgage-backed security spreads will return to normal. With the Fed reducing the size of interest rate hikes, the clouds are beginning to part for the mortgage REIT sector. That said, the dividend is not a sure thing, and investors should understand the risks.
