Mortgage real estate investment trusts (REITs) are being defended by Doug Harter, the analyst who follows this sector for Credit Suisse. The thesis is that as book values keep rising, there is still a favorable balance between risk and reward. Harter even raised some of his target prices among these stocks.
As a reminder, REITs have higher yields in the market than traditional dividends. And mortgage REITs generally even have much higher dividend yields than traditional REITs — except when the tide turns in interest rates and in the performance of mortgages.
The first part of 2014 has been favorable to the mortgage REIT sector, both in terms of rates and spreads. While we expect the environment to turn less favorable over the next 12 months with rising rates and widening Agency spreads we think the discounts to book value reflect this expectation. The majority of the expected return from the sector will come from the 11% dividend yield, which we find attractive in the persistent low rate environment.
The target price changes are based on a new 12-month forward book value expectation, generally using a 6% discount to forward book value for the agency-only names and a book multiple for the hybrid names.
Two Harbors Investment Corp. (NYSE: TWO) is Harter’s top pick among the securities-focused REITs. This is based on a combination of attractive risk/reward of the securities book value, as well as the build-out of the MSR and jumbo conduit businesses. Two Harbors trades at $10.57, against a 52-week range of $8.94 to $11.65. It comes with a current 9.9% dividend yield, although its dividend payout trend has been in decline.
Harter also singled out Apollo Residential Mortgage Inc. (NYSE: AMTG) and ZAIS Financial Corp. (NYSE: ZFC). These are both said to offer attractive risk/reward at current levels. Harter believes that their discount to book do not seem consistent with the amount of risk he sees to future book value. We would point out that Apollo Residential Mortgage and ZAIS Financial each have a current yield of 9.7%. The latter is worth only $131 million in market cap.
Some of the driving forces are an expected continued decline in interest rate exposure for the mortgage REITs. Harter thinks that the mortgage REITs have 6.2% book value exposure on average to a 100 basis point move in the 10-year Treasury — less than the 7.2% last quarter. Shorter duration rebalancing drove the change.