Understanding Agency REITs

Introduction

Following numerous inquiries after our previous piece, "Agency REITs For A Bull Steepener," we decided to provide a more detailed analysis of agency REITs. This article doesn't recommend specific agency REITs, but it does offer some fundamental basics of the largest publicly traded agency REITs. This analysis, along with the previous article, provides a solid foundation for further evaluating agency REITs.

It's worth noting that most agency REITs offer preferred shares. While we do not discuss them in this article, preferred shares may also prove rewarding and less risky in the current bull-steepening interest rate environment.

Managing A REIT

The success of an agency REIT largely depends on its portfolio management team. The team must buy rewarding assets and issue appropriate liabilities to fund the investments, but it must also constantly hedge the portfolio for interest rate and mortgage spread risk. They actively trade derivatives to transform the terms and conditions of their liabilities.

Due to the leverage employed by the agency REITs, a firm making poor hedging decisions could be forced to sell assets or issue liabilities at inopportune times. Poor management can result in reduced or missed dividend payments. On the other hand, over-hedging can significantly reduce the REITs profits, resulting in minimal dividends. The portfolio manager’s skills in managing the portfolio can make a big difference in returns when comparing REITs.

Evaluating Agency REITs

Evaluating agency REITs requires unique tools due to their distinct business model. Investors prefer metrics like price to book value, leverage, interest rate spreads, dividend reliability, and value at risk. Traditional margin and valuation calculations are not as helpful.

The price to book value tells investors how much portfolio value or equity they own per share. Ideally, investors should prefer a price-to-book value ratio below 1.0 as they essentially buy the portfolio for less than 100% of its value. However, a price-to-book value ratio well below 1.0 may indicate trouble.

Agency REITs are incentivized to grow as a larger portfolio creates more income for the company executives and the portfolio management team. Growing entails issuing more equity. Agency REITs often offer new shares to the market when the price-to-book value is above 1.0. Doing so allows them to raise more money per share than the net portfolio value. New issuance often causes the stock price to decline toward a price-to-book ratio of 1.0.

Leverage

The amount of leverage is an essential gauge of risk. A 2% adverse move in the portfolio would wipe out the entire equity value. Conversely, 5x leverage takes a 20% loss before equity holders are wiped out. Not only is the amount of leverage essential to track, but how and when the leverage changes can help us gauge the portfolio manager’s stance toward present risks.

Dividend Reliability

Given the outsized dividend yields on agency REITs, the reliability of the REIT’s dividend is important. Like other key metrics, we should compare the current dividend to its historical range to appreciate how it can potentially change in favorable or adverse environments.

An Agency REIT Alternative

If you are uncomfortable picking specific agency REITs, we recommend diversifying among many to reduce idiosyncratic portfolio risks. One way is via the iShares Mortgage Real ETF (REM). The ETF’s two largest holdings, accounting for over 25%, are NLY and AGNC.

Summary

Without a background in managing a portfolio of mortgages, analyzing agency REITs can be challenging. However, putting in more homework than is typical for a stock investment can provide investors with returns often uncorrelated with the broader market, thus offering a unique form of diversification. If you decide to research agency REITs, we highly recommend you read their quarterly and annual reports, which are incredibly detailed and insightful.

Agency REITs are not for buy-and-hold investors. They tend to perform well in specific economic and interest rate environments and poorly in others. We believe the current bullish steepening shift in the yield curve could offer investors opportunities with the agency REIT sector. However, we stress REIT portfolios can gain value while its shares lose value.

Bottom Line

Investing in agency REITs can be a complex process that requires a deep understanding of the market and the ability to analyze various factors. However, with the right tools and knowledge, it can provide a unique form of diversification and potentially rewarding returns. It's crucial to remember that these investments are not for everyone and require careful consideration and constant monitoring. What are your thoughts on this topic? Feel free to share this article with your friends and discuss it further. Don't forget to sign up for the Daily Briefing, which is available every day at 6pm.