Most investors look to mortgage REITs (mREITs) for their higher rate of return when compared to other real estate investment trusts (REIT) that own and manage physical real estate. While mREITs do carry more risk and debt than most equity REITs, the rewards of higher returns typically outweigh the risk for the right investor. AGNC Investment Corp (NASDAQ: AGNC), the largest mREIT by market cap, has made a strong comeback after a startling start to 2020. Let's take a closer look at the company today and where AGNC Investment Corporation could be in three years.
Unlike other mREITs, AGNC Investment Corp doesn't originate mortgages. Instead, the company uses its in-house subsidiaries to help package, buy, and sell government-backed mortgages secured by residential real estate. In 2020, the company completed $1.4 billion of accretive capital transactions, having a total portfolio of $96.6 billion in agency mortgage-backed securities (MBS) and to-be-announced (TBA) securities.
The company's net interest margin, or net spread, for 2020 was $2.70 per common share, a 25% increase from 2019, a good indication of improved financial performance for an mREIT. However, the low interest-rate environment has encouraged homeowners to refinance their mortgages, prepaying loans at record rates.
AGNC's constant prepayment rate (CPR) -- or the percentage of the portfolio that is expected to be paid off within a year -- at year-end 2020 was 17.6%, a significant increase from the 2019 year-end CPR of 10.8%. Early payoffs are challenging for mREITs because income is earned by collecting interest. When a mortgage is paid off early, especially if the loan carried a higher interest rate than today's market demands, the company is stuck recapitalizing its money in a lower-interest rate environment, thus earning less.
Q4 2020 AGNC had an "at risk" leverage ratio of 8.5x, an improvement from its leverage ratio of 9.4x in Q4 2019, however still a bit higher than the industry average of 8x. Despite improvements in certain metrics, net book value for the company decreased 5.3% from the previous year.
Where AGNC may be in 3 years
There are a lot of unknowns and risks when assessing AGNC Investment Corp's position in three years that could drastically change the direction and outcome of the company's future.
Right now there are still hundreds of thousands of delinquent mortgages relating to the global pandemic. This puts mREITs in a particularly tough position. If the government decides to extend the mortgage moratoriums, this could mean the companies servicing mREITs like AGNC would be unable to foreclose and financially responsible for maintaining the payments to investors despite a large portion of loans not paying.
The concern over liquidity reached its peak in early summer 2020, which is when the government stepped in to ease concerns. Since then, the financial and mortgage industry, especially those who operate in agency-backed mortgages, have relied heavily on government intervention to purchase mortgage-backed securities in the repo market in order to keep the system afloat. In the event the government stops purchasing these loans on the secondary mortgage market without full recovery of this sector, AGNC among many others would surely feel the impact.
Interest rates are also putting financial stress on the company today. Low interest-rate environments are great for borrowing but not great for lenders who rely on the spread between the cost to borrow and the money received from lending, especially as higher interest-rate loans continue to pay off. Raising interest rates would actually benefit the company over the next three years; however, if interest rates stay flat, there's a good chance so will revenues.
If all goes perfectly, that is interest rates rise slowly, the economy continues to recover, and the financial markets continue to receive financial support, in three years, AGNC Investment Corp. could be in an even better and bigger position than it is right now. However, if any of these factors go awry, there's a good chance the company will see a decline in revenues and not enough capital to pay its financial obligations.
I personally think investing in mREITs, especially one that relies so heavily on government intervention in order to operate, is rather risky right now. Considering its dividend return only achieves investors an 8.2% return at its current share prices, I don't think the three-year potential is worth it even though it's trading below 2020 highs. I believe there are far safer mortgage real estate stocks and mREITs to invest in right now that have a brighter and more diversified future.