Buy CMO, Avoid the mREIT Trap

by Bryan Perry | December 4, 2013 1:51 pm

Mortgage REITs (mREITS) are selling at a significant markdown, which means there’s a lot of discussion about whether they’re discounted or just dogs. Most pay a significant dividend that could provide some downward price protection, but there is a lot of uncertainty with regard to tapering and other interest rate concerns. So, is it time to add some mREITs back into your portfolio?

Yes and no. I don’t like the risk/reward for fixed-rate mREITs. I’m concerned we could see a spike in the 10-year Treasury note to 3.5% if the economy picks up speed, which will put fixed-rate mREITs under pressure. That said, I think there are select adjustable-rate mREITs that are worthy of a spot in your portfolio. One I do recommend in my Cash Machine Aggressive High-Yield portfolio is Capstead Mortgage (CMO[1]).

CMO operates as a real estate investment trust in the United States, investing in a portfolio of residential mortgage pass-through securities. The holdings consist of adjustable-rate mortgage securities issued and guaranteed either by government-sponsored enterprises or by an agency of the federal government.

CMO is different than comparable mREITs in that it borrows short-term and lends short-term, a proven model for success when there is no credit-default exposure and low overhead. When long-term rates rise, people have less incentive to refinance their short-term variable-rate mortgages to lock in cheap long-term fixed rates. Thus the recent near doubling of 10-year Treasury rates is very positive for the future of CMO. When short-term rates finally rise, CMO’s mortgage holdings will see rates adjust right along with CMO’s borrowing costs.

Compared to agency fixed-rate residential mortgage-backed securities (RMBS) portfolios, CMO should see smaller fluctuations in portfolio values due to changes in interest rates and/or mortgage rates. CMO is recognized as the most defensively positioned agency mortgage REIT.

It is self-managed, and its management team is experienced. Its top four executives have more than 85 years of combined mortgage finance industry experience, and since Capstead was started in 1985, it has navigated two recessions. It has a five-year compound annual total return of 18%, which exceeds that of the NAREIT Mortgage REIT Index. It is also currently paying a very respectable 10.3% annual dividend.

When the ground shifted under the bond market during the summer, it didn’t matter what type of assets a REIT owned, they all got hit in a full-on “throw the baby out with the bathwater” selloff. Now that the bond market has settled down, the sector is going through a weeding-out process[2] that will show CMO to be well-positioned. I see the stock charging from current levels around $12 up to $15.

Give it a good look if you haven’t already.

As of this writing, Bryan Perry was long CMO.

  1. CMO:
  2. a weeding-out process:

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