mREITS make their living by borrowing money at low, short-term interest rates and then buying government-guaranteed mortgage bonds that pay higher, long-term rates. They earn money on the “spread” between those two rates. They’re basically a form of a bank, only without branches, bankers, and bank commissions. As of late, shares of companies in the mREIT sector such as Annaly Capital Management, Inc. (NYSE:NLY), American Capital Agency (NASDAQ:AGNC) and Invesco Mortgage Capital Inc (NYSE:IVR), have fallen dramatically. Let’s try and figure out whether we have value investments or a value traps in our hands.
The spread is their friend
As I mentioned earlier, mREITs make money from the spread between short-term and long-term interest rates. The higher the spread – the better. Historically, yield curves flatten out prior to the economy going into recession. They may even invert, as did happen in 2006-07 and again during the Great Recession. I don’t believe we are heading into a recession. While the U.S. economic recovery has been tepid, and I agree it may accelerate soon, I question the premise that we are heading into another downturn. Indeed, if the Fed gets even a whiff of recession, the “tapering” argument gets blown out.
On the other hand, if the Fed does begin to reduce its willingness to buy up long-treasuries, conventional wisdom says this action will tend to push such securities’ yields higher, not lower. At that same time, the Fed (which has considerably more control over short-term rates) could act to maintain these low rates. Over time, such a stance would widen the spread, not diminish it.
The only problem with a sudden spike in interest rates is that when interest rates rise, the value of the existing mortgage bonds Annaly Capital Management, Inc. (NYSE:NLY) and other mREITs hold falls. That’s why investors have pushed Annaly’s share price down 18% over the last two months. American Capital Agency Corp. (NASDAQ:AGNC) and Invesco Mortgage Capital Inc (NYSE:IVR) followed the same path with a downfall of 21% and 15%, respectively. In other words, there’s currently a heavy short- term pressure on book value because of the spike in rates. And that’s exactly where our opportunity lies. We know that, in time, higher rates bring with them a higher spread. Higher spread spells more profits for mREITs. It’s a win – win.
For any REIT, the preferred plot is price as a function of FFO (Funds from Operations). FFO is close kin to operating cash flow, from which the book value is derived. Earnings per share mean little to mREITs. Cash is king. Consensus Wall Street analysts forecast Annaly Capital Management, Inc. (NYSE:NLY)’s future cash flows to increase in the low single digits. If so, the price-to-FFO line should not retreat. Therefore, unless the historical trends are now somehow broken, the price will eventually follow. Even at a P / FFO multiple of 6, this year’s projected FFO indicates a 2013 price of nearly $19 a share. Applying the same calculation to American and Invesco Mortgage Capital Inc (NYSE:IVR) result in share prices of $33 and $25, respectively. That’s roughly a 30% upside from today’s current prices.
Another way to value mREITs is to calculate their book value per share. For example, Annaly Capital Management, Inc. (NYSE:NLY)’s book value per share is currently $15.20. With shares trading hands at $13.36, we are looking at a discount of 13% to book value. Keep in mind that whenever shares traded at a 10% discount-to-book in the past, they have always tended to regress back to the mean, that is – to their book value within a year. That means that if history is any guide, by buying now you are potentially securing a 13% return (plus dividends) on your invested capital. That’s impressive. Even American Capital Agency Corp. (NASDAQ:AGNC) and Invesco Mortgage Capital Inc (NYSE:IVR) are trading at large discounts of 11% and 12% to book value. Opportunity is abound.
The Foolish conclusion
I strongly believe that after the strong sell-off that the mREIT sector has experienced, it’s finally on the verge of a fierce rebound. A higher spread will eventually lead to bigger profits for all mREITs. Make sure your’e on board.
Shmulik Karpf has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article How to Make the Fed Pay You originally appeared on Fool.com.
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