The mortgage Real Estate Investment Trusts (REITs) sector is currently experiencing a month of wealth destruction, with book values and share prices plummeting. Unfortunately, these losses are not temporary fluctuations; they represent permanent losses due to significant swings in interest rates.
In September, I issued several warnings to investors about the potential risks in this sector. For those who heeded these warnings and took measures to protect themselves, congratulations. Now, let’s dive into some recent results to gain a deeper understanding of the situation.
AGNC Investment (AGNC) Preannounces Results
AGNC Investment, one of the prominent players in the mortgage REITs industry, recently preannounced their results. One can’t blame them for taking this step, considering an analyst’s estimate suggesting a tangible book value (BV) of $7.85 per share with net spread and dollar roll income of $0.65 per share. These optimistic projections were just too good to be true.
Additionally, AGNC Investment disclosed their estimated BV as of October 20, 2023, stating that the mid-point of their range was $6.90. It is noteworthy that my earlier estimate for the same day stood at $6.85 per share. The accuracy of these book values is quite surprising, almost as if Halloween came early this year.
AGNC Investment was likely hoping that the decline in their share prices wouldn’t be as severe as it turned out to be. A moderate drop could have presented an excellent opportunity for them to issue shares, given their significantly high premium to tangible book value. However, AGNC’s shares closed at $8.11 on October 23, 2023, compared to the current price of $7.16, reflecting an 11.7% decline. Even after-hours trading witnessed a drop of up to 10%. All in all, the bears were having a field day.
Forecasting Obvious Price Declines
AGNC Investment’s shares were trading at an exorbitant 1.2x tangible book value, which was clearly an overpriced valuation. Investors had the opportunity to invest in other similar companies at book value. Consider this scenario:
- $100 for $100 of equity in a peer
- $120 for $100 of equity in AGNC Investment
It’s evident that it is more beneficial to invest in equity from a peer company at an equal value rather than paying a premium for AGNC Investment. There are several other competitors in the market with assets just as good as AGNC’s. In situations where there is a large gap in valuation, it is wise to avoid investing in the overpriced option.
It is crucial to note that this forecast of the decline in AGNC Investment’s share price is just the tip of the iceberg. The real question is how we predicted the plunge in their book value.
Forecasting Book Values
Asset values took a significant hit, as depicted by the sharp decline in 30-year MBS prices. While hedges managed to produce some gains, their impact was minimal in comparison to the decline in assets. Given the highly leveraged nature of AGNC’s business model, the swing in book value was much more pronounced.
Understanding Book Value
Let’s touch on a quick lesson here. Should an agency mortgage REIT be trading at a substantial premium to its book value? Absolutely not. A new REIT can be created at book value itself. So why should anyone pay a premium to buy a portfolio of Mortgage-Backed Securities (MBS) and hedges? In such a scenario, if a mortgage REIT trades at a significant premium, it should issue new shares. Essentially, by having someone buy shares at a higher price, the REIT increases its book value. This concept can be likened to how mutual funds work.
Imagine owning 1/10th of a mutual fund that has $1,000 of assets (ignoring overhead expenses for simplicity). In this case, your position is worth $100. Now, imagine there is a prospect who is willing to buy 5 shares for $115 each. Pretend this is legal because, in the case of publicly traded REITs, it is. So, the fund issues 5 shares at $115 and adds the cash to the fund. Now, there are 15 shares outstanding, and the total value of the fund is $1,575. Consequently, the value of your 1 share increased to $105. You gained an additional $5 in value. This holds true as the new capital is invested in assets similar to the existing ones, essentially increasing your position’s share of the fund’s assets.
While the increase in shares outstanding and book value won’t be as drastic in reality, even a minimal gain can be significant. Getting 1% more of everything is still a great advantage. Who wouldn’t want an extra 1% in every position? If your broker offered you such an opportunity, you would undoubtedly jump at it. Issuing additional shares above book value is a beneficial move for mortgage REITs.
However, the same principle does not apply to equity REITs since their assets are relatively unique and book value holds little meaning under Generally Accepted Accounting Principles (GAAP). For equity REITs, if they trade above their Net Asset Value (NAV), it is generally advisable to issue new shares.
Battle Call of the Fish
At any poker table, you will find a mix of sharks and fish. Over time, the sharks end up taking money off the fish. There’s a saying in poker, “If you can’t spot the fish, you are the fish.” Similarly, there’s a common battle call made by the fish in investment circles:
“When interest rates decline, mortgage REITs will do exceptionally well. AGNC will skyrocket.”
Unfortunately, this notion is incorrect. AGNC Investment itself provided evidence to the contrary. They clearly communicated their exposure to losses resulting from changing interest rates.
Other Mortgage REITs’ Results
Moving on to Annaly Capital Management (NLY), another major player in the mortgage REITs sector, they recently announced their results. NLY experienced a smaller BV loss of 12% compared to AGNC. In contrast, ARMOUR Residential REIT (ARR) faced a much larger decline.
As we await the results from Two Harbors (TWO), Cherry Hill Mortgage (CHMI), and Invesco Mortgage (IVR), it is safe to anticipate more carnage in the agency mortgage REITs space. Most other mortgage REITs are expected to have moderate book value losses. On the flip side, Business Development Companies (BDCs) are performing much better than predicted.
Main Street Capital (MAIN), for example, reported a modest gain in book value as they demonstrated their ability to navigate the current environment smoothly.
The past quarter has been tumultuous for agency mortgage REITs. Investors were counting on interest rates remaining steady, but if you project a significant decline in rates, investing in this sector is not advisable. While these REITs could perform well if rates stabilize, investing in them currently is extremely risky. It is always dangerous to invest in stocks without a thorough understanding of them, even more so if you plan to hold onto them despite unfavorable market conditions like reverse splits and dividend cuts. Please exercise caution.
Editor’s Note: This article discusses microcap stocks. Please be aware of the risks associated with such investments.