The key to the mortgage REIT sector right now is the preservation of book value. Given the relative strength of the non-Agency MBS market, hybrid mREITs have been able to withstand the volatility of the market better. Therefore, this protection of book value leaves the hybrid mREITs in a better position to continue to deliver returns and potentially take advantage of the better spread environment on Agency MBS today than their pure-play counterparts. Among the residential hybrids, Two Harbors Investment Corp (NYSE:TWO) remains my top pick. Now, the mREITs business model is complicated. This article aims to educated potential investors about it and see why Two Harbors remains my top pick.
What is an mREIT?
Real estate investment trusts that invest in mortgage backed securities are called mREITs. They invest in longer duration MBS using short-term financing (repos) and earn a spread between what they earn on their interest earnings assets (MBS) and what they pay on their interest bearing liabilities (repos). The spread is leveraged to magnify the returns.
What is an Agency mREIT?
Agency mREITs are companies that invest in mortgage backed securities for which any of the government Agencies such as Fannie Mae and Freddie Mac guarantee the principal and interest payment on the MBS held. These MBS are usually backed with single-family residential mortgage loans.
What is a hybrid mREIT?
Like Agency mREITs, hybrids invest in Agency RMBS. However, they have non-Agency MBS, commercial mortgage backed securities (CMBS) and a variety of other real estate related assets in their investment portfolios. Non-Agency MBS are MBS issued by private mortgage originators while commercial MBS are backed with commercial loans, instead of residential loans.
Why I prefer hybrids
As noted above, hybrids are invested in a variety of real estate related assets that provide the company with diversification. While diversification can put a cap on the returns, it also acts to provide sufficient cushion to the book value when the interest rates start climbing.
Two Harbors Investment Corp (NYSE:TWO) is invested in Agency and non-Agency MBS. Besides, it is also invested in commercial MBS and real estate facilities from which rental income comes. While this diversification obviously supports the bottom line and provides a cushion to the book value, Two Harbors Investment Corp (NYSE:TWO) has pursued other strategies to ensure book value preservation.
Two recently announced it is moving into other areas like Prime Jumbo Securitization, credit sensitive loans, mortgage servicing rights and other credit instruments. Expansion into these areas will make Two Harbors Investment Corp (NYSE:TWO) less reliant on the Agency MBS markets, which are facing tremendous volatility due to the Fed’s actions.
Further, Two Harbors Investment Corp (NYSE:TWO) recently announced that it had over $2 billion long to be announced (TBA) positions to over $2 billion short TBA positions during the second quarter of the current year. A TBA position is a forward mortgage backed security trade. An actual MBS is delivered to fulfill a TBA trade. This strategy, coupled with its hedges, is why I feel comfortable that Two Harbors has protected its book value better than most of its peers.
Why not pure-play mREITs?
Among the pure-play mREITs Annaly Capital Management, Inc. (NYSE:NLY) and ARMOUR Residential REIT, Inc. (NYSE:ARR) are two of the most followed stocks. However, both have seen their stock prices nosedive over the past few months. A primary difference between the hybrids and pure-play mREITs is the composition of their portfolios. The anticipated halt in the Agency MBS purchases by the Fed is causing significant book value depreciation among the Agency mREITs. While the book value of some mREITs is more exposed to changes in interest rates, others have done well to cushion theirs.
