2015 has been unkind to the mortgage REIT sector. The iShares Mortgage Real Estate Capped (REM), a basket of the largest and most actively traded mortgage REITs, is down a little over 8% year to date. Including the large dividend, that loss shrinks to about 4%. But it’s been a rough ride, and I haven’t seen any indication that it’s over. This is every value investor’s frustration: A cheap sector that just keeps getting cheaper.
Consider the case of Annaly Capital Management (NLY), the largest m-REIT by market cap. Annaly has spent virtually its entire history as a public company trading above its book value — as it should. As an investor, you should be willing to pay a modest premium for Annaly’s management expertise and its low cost of capital.
But in 2012, something changed. Investors became less and less willing to pay up for Annaly’s shares, and they pushed the price into discount territory. That discount has been widening ever since, and today Annaly trades for just 80 cents on the dollar.
A discount to book value would imply that management is actually destroying value. And hey, plenty of management teams actuall do destroy value. But it’s hard to argue that the management teams of the entire sector are destroying value, and yet that’s what market prices currently imply (see slide 31 in my last client presentation).
So, what gives? Why is the market pricing in such doomsday valuations?
You can blame it on two factors:
- The flat yield curve of recent years caused m-REITs to reduce their dividends. Remember, m-REITs borrow short-term and lend long-term, so a flat yield curve reduced the funds available for dividends. Investors, burned by a cut dividend, have responded by dumping the stocks.
- Fear of the Fed is playing a role as well. Investors…despite all evidence to the contrary…still seem the think the Fed will aggressively raise rates in the months ahead. Higher short-term borrowing costs will further crimp dividend payments.
So, what should we do about it? Are m-REITs worth buying at these prices, or is Mr. Market correctly pricing in risk?
I’ll allow DoubleLine Capital’s Jeffrey Gundlach to answer that question.In last week’s Barron’s, Gundlach pretty well summed it up:
Annaly is a mortgage REIT [real-estate investment trust]. It buys mortgage securities and leverages them, creating interest-rate risk. But I don’t expect the Federal Reserve to raise interest rates any time soon, and long-term rates are range-bound. [Emphasis Charles]
In this environment, Annaly’s near-12% dividend yield looks stable. Moreover, the price of the shares could rise because Annaly is trading at a substantial discount to the value of its portfolio of assets. The REIT sector broadly has been weak for the past 18 months because of fears the Fed might raise rates.
I agree with Gundlach. Though to be fair, we’ve both been very early to this party. I’ve been writing about the attractive pricing in m-REITs for well over a year now, and Mr. Gundlach was publically praising the sector as far back as 2013. We’ve both been very early to this trade.
Of course, we’re also being paid to wait. Mortgage REITs have continued to pay exceptionally high dividends throughout the turbulence of the past few years. And I don’t expect that to change any time soon.
