2 Small-Cap mREITs & 3 Top High-Yield Picks From Credit Suisse

Investors are attracted to the mortgage REIT (mREIT) asset class because of the high dividend yields; however, these high yields need to be weighed vs. potential losses in book value which can play havoc with total shareholder returns. On June 29, Credit Suisse analyst Douglas Harter published a research note reinstating coverage on two small-cap names at Neutral:

• Anworth Mortgage Asset Corporation ANH $524 million cap, 12 percent yield.
• Ellington Residential Mortgage REIT EARN $134 million cap, 15 percent yield.

However, Harter's three top picks in the mREIT space continue to be:

• New Residential Investment Corp NRZ $3.6 billion cap, 11.6 percent yield.
• PennyMac Mortgage Investment Trust PMT $1.34 billion cap, 13.6 percent yield.
• Two Harbors Investment Corp TWO $3.6 billion cap, 10.5 percent yield.

Tale Of The Tape - Past Year

The chart above illustrates how share price declines can mitigate, or even overshadow, the dividend yields when calculating the total annual return on an mREIT investment. New Residential pursues a different business model which is focused on mortgage servicing rights (MSRs), rather than owning a leveraged portfolio of mortgages and related securities.

Credit Suisse - mREIT Big Picture

Overall, Credit Suisse views this sector as having a positive risk/reward profile, pointing out that mREITs are trading at an average discount to book value per share (BVPS) of 19.6 percent. Harter made the point that operating in a rising rate environment, (both short-term and long-term), has resulted in the discounted valuations. Notably, Anworth Mortgage and Ellington Residential are trading at discounts to BVPS of 22.8 percent and 13.3 percent, respectively.

Credit Suisse - Leveling The Playing Field

Harter's favorite mREIT metric "is the average quarterly economic return divided by the volatility of that return." Credit Suisse noted, "The volatility in the markets has been displayed through considerable swings in both interest rates and Agency MBS spreads." "In this type of environment, mREITs with more effective risk management strategies will be better equipped to navigate through the volatility and produce better economic returns," according to Harter. Based upon this performance measure, PennyMac and New Residential rank first and second, with Two Harbors ranked fifth; while Anworth and Ellington are in the middle of the pack.

Credit Suisse - Bottom Line

"We continue to favor the mREITs that are creating operating businesses and can create their investments."

Investor Takeaway

While the New Residential MSR-focused business model certainly fits this description, companies involved in mortgage servicing -- especially non-performing loans (NPLs) -- have been under tremendous regulatory scrutiny. A prime example of these risks, would be the Ocwen/Altisource family of companies, which have lost 70 to 80 percent of their values as a result of mortgage servicing business practices found to be in violation after state and federal regulatory investigations. Notably, HLSS was part of the Ocwen family of companies, and this regulatory upheaval is what created the NRZ buying opportunity for these valuable MSR assets.