Hate cannot drive out hate, but it can create a good investment opportunity!
It’s not often that I want people to hate. However, when investors overly hate a stock, it can lead to trading on emotion instead of fundamentals. That’s when patience can pay off.
Further, we don’t advocate that people lie.
Without further ado, let’s jump into the opportunity built on hate and lies!
Why Investors Hate MITT
AG Mortgage Investment Trust (MITT) is a small mortgage REIT. They’ve dramatically underperformed peers on share price so far in 2019, leading to our decision to issue a buy rating. We need to ensure that readers recognize the difference between fundamentals and share prices. The share price has been weak, but the fundamentals didn’t change much.
We also disliked MITT’s price once upon a time when we wrote that investing in them was a stinky decision:
Source: Seeking Alpha
Since then, the price has dropped materially. We no longer believe shares are overpriced. Further, we have upgraded MITT to a buy rating.
Let’s start by identifying MITT.
MITT owns a mix of agency RMBS, non-agency RMBS, and commercial loans. They also have a tiny (and dumb, since we’re being clear) allocation to single-family rentals. This hasn’t been a bad year for REITs that own non-agency RMBS, commercial loans, or single-family rentals. It has been rough for REITs with most of their capital allocated to agency RMBS.
Mortgage REITs evaluate their exposure to each area based on how much equity they are investing in the strategy. We can see MITT’s portfolio composition over time below:
While their allocation to agency MBS increased slightly, it’s still only 41.4% of the total.
Most mortgage REITs focused on residential credit (the green section) still own a material allocation to agency MBS (the blue section). Overall, this portfolio isn’t very unique. That’s important. If it were unique, there could be an argument for it trading at a much weaker price. Because it’s similar to peers, it should be priced similarly.
The Market Still Likes Credit Risk on MBS
Many mortgage REITs with heavy allocations to credit risk are commanding much higher price-to-book ratios than mortgage REITs focused on agency MBS. Real estate values have been moving higher while interest rates declined. Defaults are quite low. It’s been a good time to have this risk. You collect a solid level of interest and few homeowners defaulted. That’s precisely what the REIT wants. Yet, if you’re reading through MITT’s presentations, you wouldn’t know it was a great time for non-agency mortgage REITs. That leads to a simple (and wrong) explanation. We call it the popular lie because the false widespread belief is damaging MITT’s share price.
The Popular Lie
To understand why MITT’s share price is performing poorly, investors need to understand what the market thinks. To do that, we need to go through the presentation and identify what most investors are going to see. We always want to examine the other thesis for our investments. If we’re going to be bullish, we want to understand what the bears are thinking.
An incorrect thesis often starts with a few accurate statements. This is especially true when it comes to mortgage REITs. Investors (and analysts) have a few correct facts. During the analysis process, they misinterpret the data and reach an inaccurate conclusion. We will start with a few accurate facts and a dose of sarcasm.
Core EPS and the Dividend
Consider the Core EPS and dividend over time:
Remember that Core EPS is a mediocre metric when used in isolation (though the market loves it). There are ways to artificially increase or decrease Core EPS. One of the simplest ways to artificially change Core EPS is to play with the hedging strategy. Few investors really understand how hedging and financing work. As we will demonstrate, hedging decisions here are creating a lower value for Core EPS. We aren’t saying that this is done on purpose. However, we do believe it is happening.
The Yield on Assets, Cost of Funds, and Net Interest Spread
If you want to see how MITT creates lower core earnings, you can jump to these three metrics.
The yield on assets minus the cost of funds gives us the net interest spread. MITT labels the net interest spread as the net interest margin. The metrics are similar enough that we don’t want to go into the difference here.
If you want to improve the net interest spread, you need to either increase the yield on assets or decrease the cost of funds. Unfortunately, most investors reading MITT’s presentations are going to focus on the large decline in the yield on assets. Let’s start by showing the metrics in Q3 2018, back when investors liked MITT much better:
A strong yield on assets overshadows the cost of funds. The resulting net interest spread looks pretty good. That’s wide enough for the mortgage REIT to earn a substantial amount of net interest income, which means Core EPS should be good. Indeed, Core EPS was good. Core EPS came in at $.56 for Q3 2018. Downright massive.
Now let’s consider how things have changed over the last year. We’re showing the Q3 metrics below:
Since the yield on assets fell substantially, it would be natural (and incorrect) to assume that the yield on assets is the problem. Even though the yield on assets is falling, the real problem is in the cost of funds. Remember that interest rates have been plunging. We should be seeing lower yields and lower costs. Instead, we’re seeing lower yields but the cost of funds is stubbornly high for MITT.
Blame Cost of Funds
For investors to follow our analysis, it’s critical that this point is hammered home. The yield on assets and the cost of funds should BOTH be lower:
- The decline in the yield on assets is not the problem.
- The cost of funds remaining high is the problem.
We Just Broke Away From the Bears
This is the moment in the analysis where we’re breaking away from the bears. Bears would’ve found those same facts, but they would be focusing on the yield on assets. It would lead them down the wrong path. They would see the falling interest rates and higher prepayments as evidence that the falling yield on assets was an unstoppable freight train. They expect earnings to continue getting crushed, but that’s wrong.
Artificially High Cost of Funds
Since we know the cost of funds should’ve decreased, we’re going to head down the correct path. We’re asking the right questions:
- Why did the cost of funds remain high?
- What could be done to fix it?
- Is it likely that this problem gets fixed?
Why Did the Cost of Funds Remain High?
Mortgage REITs borrow money through repurchase agreements. The term “repurchase” is used interchangeably with the word “repo.” The cost of repurchase agreements usually is the largest expense for mortgage REITs. The interest rate on repurchase agreements drives the cost of funds for the mortgage REIT.
Since we know the cost of funds is driven by repurchase agreements, let’s look at MITT’s repo agreements:
The first step is in the red box. The numbers on the left side represent the amount of repurchase agreements outstanding. The numbers on the right side represent the weighted average interest rate on those repurchase agreements. Those costs remain high. That isn’t a unique problem though. That’s occurring for all the agency mortgage REITs. How could it be a big problem for MITT when it is a smaller problem for peers? Did those peers have a way to solve it? They did. The cure is a huge swap portfolio. We can measure a swap portfolio by comparing it with the repurchase agreements.
We placed a green box around the $2,523.9 million in outstanding repurchase agreements used to finance the portfolio of agency securities. We will compare the outstanding repurchase agreements with MITT’s swap portfolio.
Does MITT Have a Swap Portfolio to Fix It?
MITT does have a swap portfolio, but it’s tiny. How big is MITT’s swap portfolio compared to the $2,523.9 million in outstanding repurchase agreements for agency securities? We are only going to be comparing the swap portfolio. Therefore, we are excluding “Swaptions,” “British Pounds Futures,” and “U.S. Treasury Futures.”
Let’s take a look:
MITT has a significant hedge portfolio, but a significant chunk of the hedge portfolio is not a “swap”.
That’s actually a big deal. While those hedges still work to protect book value, they have ZERO impact on the cost of funds. That’s the issue. While peers are dropping their cost of funds through their hedging techniques, MITT’s hedges are not hitting the cost of funds in the same way.
What’s MITT’s Percentage?
If we compare the notional amount on swaps (that’s $1,437.9) to the outstanding balance on repo agreements for agency securities (that’s $2,523.9), what do we get? 57%. That’s the portion of their agency repurchase agreements covered by swaps.
In this math, we didn’t apply a single penny of hedging toward the non-agency assets. If we did, the percentage would be much lower than 57%.
What Did Other REITs Do?
Let’s take a look at a mortgage REIT which just blew away analysts with their earnings release: AGNC Investment Corp. (AGNC). Is AGNC a great peer for MITT? No. AGNC doesn’t have much capital in credit-related assets (those were 54.7% of MITT’s portfolio).
However, AGNC is a GREAT peer IF we want to make the comparison for MITT’s 41.1% of equity invested in agency MBS.
How much of AGNC’s repurchase agreements were covered by swaps?
So we have AGNC covering 86% of all their repurchase agreements.
MITT covered 57% of its agency repurchase agreements with 0% left for anything else.
How Big is the Impact?
On MITT’s interest swaps, the weighted average pay-fixed rate was 1.7% and the weighted average receive rate was 2.2%. That’s a spread of 50 basis points (same as saying 0.5%).
If they had a notional balance of $2,449 rather than $1,438, how much would that have improved net interest income for MITT?
By our estimates, that would have generated an extra $.15 per share on an annual basis. That’s nearly $.04 per share on a quarterly basis. That would be a pretty big boost when last quarter’s Core EPS was $.40. This technique creates an almost 10% increase and nearly closes the entire gap between Core EPS and the dividend.
Is That Even Reasonable?
We think so. This would cover 97% of agency repurchase agreements. That sounds high, but it leaves nothing for the credit-related assets. If we count the credit-related assets, our hypothetical balance of $2,449 in notional swaps would only cover 64% of the total debt. AGNC covered 86%, so that doesn’t seem too unreasonable.
Where did we get that number though?
That was the notional balance for swaps in MITT’s portfolio from Q3 2018 (rounded from $2448.8). You might think that MITT was hedging a larger portfolio back then. No.
In Q3 2018 MITT had $1,880 in repurchase agreements for agency assets.
Now MITT has $2,524 in repurchase agreements for agency assets.
The size of the portfolio increased materially, but the size of the swap portfolio shrank dramatically.
Could MITT Even Get Those Swaps?
We’ve suggested that MITT’s net interest income could be boosted by substantially increasing their position in interest rate swaps. That begs an important question. Are such swaps even available today? Well, MITT’s swaps had a weighted average fixed-pay rate of 1.7%.
As of 11/4/2018, when we checked, we saw the following swap rates available for LIBOR swaps:
- 3-year swap: 1.6%
- 4-year swap: 1.58%
- 5-year swap: 1.58%
Consequently, we’re going to say: “Yes, they could do that.”
An Even Cheaper Technique
On AGNC’s earnings call, Peter Federico (Chief Operating Officer of AGNC) stated:
Source: AGNC’s earnings call
This option also is available to MITT. LIBOR is going away in the future. We demonstrated what MITT could do using LIBOR swaps. Currently, all of MITT’s swaps are LIBOR swaps. When (or if) MITT wants to change which kind of swaps they use, these options are available. If MITT wanted to, they could begin entering these short-term hedging contracts to lock in a much lower cost of funds.
Why Would They Wait?
Is there any good reason for MITT to wait? We can think of one. If MITT believes we will see a further dip in short-term rates, they could be waiting in hopes of locking in a slightly better rate in the future. That’s a portfolio management decision and it creates one plausible explanation. If MITT adds more swaps in the near future, they could see a nice boost to Core EPS.
Review of Core EPS, Yields, Cost of Funds, and Net Interest Spread
Let’s take a moment to review what we’ve covered for the main mortgage REIT metrics:
- MITT’s Core EPS declined dramatically.
- The fall in Core EPS is driven by a reduction in their net interest spread.
- The yield on assets fell, but that should be expected.
- The net interest spread decreased because the cost of funds remained high.
- MITT has the ability to significantly reduce their cost of funds for the near future by adding more swaps to their hedges.
- They could use LIBOR swaps, OIS swaps, or SOFR swaps. Any of those are viable.
Very recent pricing on LIBOR swaps indicates that they would still be able to enter those swaps currently (or recently, depending on when you’re reading this).
A Positive Catalyst
The upcoming sections may seem like we are ripping MITT apart. That’s not the case. MITT made a terrible mistake and they are fixing it. We’re talking about the magnitude of the problem they are correcting in Q4 2019. This mess is expected to be completely gone in 2020, but it’s one of the reasons for MITT’s dreadful performance in 2019.
Getting Rid of Garbage
There’s one more positive catalyst on the horizon for MITT. When the article opened, we referenced that a small portion of the portfolio was invested in single-family homes. We were pretty clear by highlighting the decision as “stupid.” That’s a useful word. We all know what it means.
On 11/5/2019, MITT announced they were getting rid of the SFR (single-family rental) portfolio. That’s a positive development. It could’ve been easily missed amid the excitement over earnings. The announcement came with a form 8-K, but no press release. We’ll summarize it:
“MITT is selling the SFR portfolio for $137 million. The transaction should close in Q4 2019.”
Scrapped From The Analysis
When we started working on our thesis for MITT, it was going to include a section calling for them to dispose of their rental portfolio. It appears we won’t need to do that, because management already recognized that it wasn’t delivering returns to shareholders:
Source: MITT’s earnings call
How Terrible Was It?
To understand how getting rid of this portfolio enhances their earnings going forward, you need to understand how the portfolio was damaging the mortgage REIT.
MITT spent about $140.6 million to buy a single-family rental portfolio. The portfolio was externally managed (into the ground). Operating margins were dreadful. We scrapped a more complicated presentation in favor of this:
Still gets the point across, right? 65% is very good. 40% is terrible. Really terrible. We want to hammer home just how terribly this portfolio performed. The “Gross Carrying Value” (which is before depreciation) climbed from $140.6 million at the end of Q3 2018 to $142.1 million at the end of Q3 2019.
- Rental income was $3,309 thousand for Q3 2019.
- The expenses (excluding depreciation) came in at $1,986.
- We calculate $1,323 in NOI (net operating income).
- If we annualize that (multiply it by 4), we get $5,292 thousand. That represents a 3.72% return in NOI on the $142.1 million of gross investment.
If there were any recurring capitalized expenses (which most equity REITs have), then the return was actually lower. Since the gross asset value climbed from $140.6 million to $142.1 million, we’re very confident there are some capitalized expenses. Therefore, the actual cash return was materially worse than 3.72%.
Note: Our calculations are slightly different from MITT’s calculation. MITT adds in “other income” from rental properties. We looked through the Q3 10-Q and did not see that value broken out at any point. We did see a generic line for “other income,” but the “other income” line includes income from several other activities.
When is 3.72% Much Worse than 3.72%?
Even though cash returns were already worse than 3.72% due to capital expenditures, the picture gets uglier. The portfolio was financed with a five-year loan at 4.75%.
As you probably know, earning less than 3.72% and financing it at 4.75% isn’t a big winner. The five-year loan was for $103 million. We found those details on page 131 of MITT’s 2018 10-K.
Let’s turn those percentages back into dollars. The NOI (as we calculated it) annualized to about $5,292 thousand. The interest expense would’ve been about $4,892 thousand. That leaves $400 thousand for those capitalized expenditures before we start having negative cash flows available for shareholders.
By our estimates, the capitalized expenditures were probably materially higher than $400 thousand per year, so enjoy the negative cash flows.
Yeah, we’re not done. Since $142.1 million is invested with $103 million from debt, the net equity investment is around $39.1 million. Remember that MITT was issuing preferred equity at an 8% coupon rate. If MITT didn’t have $39.1 million tied up in this portfolio, they could’ve used that $39.1 million instead of issuing the preferred shares. So what’s the marginal cost for the equity? We could use the 8% coupon rate on MITT-C (MITT.PC) as a reasonable estimate.
So how much does $39.1 million of preferred equity cost at 8%? About $3.1 million.
For the common shareholders, that’s pretty terrible. They already had negative cash flows from the deal, before the $3.1 million going to new preferred shareholders.
Remember that dividends paid to preferred shareholders reduce cash available for common shareholders.
How much was that $3.1 million worth? It comes out to about $.095 cents per common share.
That’s Not a Cherry on Top
The announcement of the portfolio sale may not have been emphasized since it’s being sold for $137 million.
As you might know, $137 million is less than $142.1 million (current gross book value).
$137 million is also less than $140.6 million (Q3 2018 gross book value).
You also might know that low-end single-family homes generally appreciated in value over the last year. So the portfolio:
- Created negative cash flows (by our estimate) before applying preferred equity costs
- Gets sold for less than original cost
So what could MITT have done instead?
Those shares were available on the stock market. No complicated action needed. They also traded at substantial discounts to consensus estimates. Further, AMH and INVH have access to cheaper debt financing than MITT used to fund their portfolio.
So investing in AMH or INVH would’ve meant:
- Huge discount to the fair market value of the real estate.
- Exposure through AMH and INVH to financing the properties at a lower rate.
- Dramatically superior economies of scale (operating margins around 65%, not 40%).
- Better liquidity. Think it doesn’t matter? Let’s think about the transaction expenses. They could easily run 1% on a portfolio transaction. That would be over $1.3 million. What’s Schwab’s trading commission? It went from $4.95 to $0.00. That’s less than $1.3 million.
I probably don’t need to point this out, but they’d be up well over 20% on the price if they bought AMH or INVH. As you surely know, a 20% gain is better than a loss.
Don’t Sweat the Decline in Portfolio Value
Assuming MITT loses around $5 million on the portfolio transaction, that would represent a non-recurring loss of about $.15 per share. It’s less than 1% of book value. It’s practically a rounding error when it’s non-recurring. It was the recurring costs that created a problem.
Now You Know
MITT’s underperformance in 2019 shouldn’t be confusing anymore. Since we understand how it happened, we can see the path back to a higher price.
Cumulative Earnings Impact
Let’s wrap this up by combining the two factors for their potential impact on earnings. By selling the SFR portfolio, they will free up about $30 to $35 million. We’ll use $33 million for the estimate. If they earn 8% (equal to their preferred dividend rate), that would add $.08 per year to Core EPS.
By modifying their hedge portfolio to include more swaps, MITT could enhance annualized Core EPS by about $.155.
Combined, that gives us an estimate of $.235 annually to Core EPS. On a quarterly basis, that’s about $.06. Trailing Core EPS was $.40 for Q3 2019. We reach an estimated figure around $.46 for a quarterly run rate.
With the portfolio sale scheduled for Q4 2019, the boost would be expected to hit Core EPS in 2020.
When management says they believe the current dividend rate of $.45 is reflective of what the portfolio could earn in the near to medium term, they may be evaluating earnings the same way we are.
MITT has been punished over the last year. Some weakness is warranted.
The decision to buy the SFR portfolio was a poor choice, but it’s headed out the door.
The current hedging strategy isn’t maximizing Core EPS.
Both factors (SFR portfolio and hedging) are weakening Core EPS for 2019. At least one is ending by the start of 2020.
We expect MITT to trade at a closer price-to-book ratio when compared with their non-agency peers. That implies a healthy amount of upside in the shares compared to their current price of $15.57.
Since we’re talking about the common shares in a mortgage REIT, we’re treating this as a trading position. We act on our thesis by owning shares and waiting for the valuation gap between MITT and their peers to close. When it closes, we walk away. Usually, that means walking away with profits. However, it’s possible that something could go wrong with MITT or that peers could plunge to close the gap in valuation.
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Disclosure: I am/we are long MITT, AMH, PREFERRED SHARES FROM AGNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.