Mortgage REITs were doing great — until the yield curve inverted

Real estate pros and economic pundits spent the better part of last week trying to decipher the greater implications of the treasury yield inversion, an economic indicator that has historically preceded a recession.

But earlier this year a different set of benchmark rates inverted, and it’s already had a significant impact on one sector of the real estate market: residential-mortgage real estate investment trusts.

Three of the largest REITs that buy up residential mortgages and package them into securities have cut their dividends so far this year. The cuts came after the yields on three-month and 10-year treasuries inverted in March for the first time in over a decade. (Last week’s inversion that sent the market into an uproar was on two-year and 10-year treasuries.)

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Annaly Capital Management, the country’s largest residential mortgage REIT, cut its dividend in May from $0.30 a quarter to $0.25 a quarter. The same month another large mREIT, AGNC Investment Corp, cut its dividend from $0.18 to $0.16 cents.

And in June Two Harbors Investment Corp cut its dividend from $0.47 to $0.40.

“That was a little surprising to see them cut,” said Brock Vandervliet, an analyst at UBS who covers Annaly Capital management. “For Annaly that was basically the first cut in five years, so that was a big deal.”

Such dividend cuts are significant for mREITs, which investors buy primarily for their high quarterly payouts. Some of the highest yield mREITs pay out dividends of 12 percent or more, compared to a yield of 2 to 2.2 percent for the Standard & Poor’s 500 Index.

Though mortgage REITs are just a small part of the $11 trillion home loan market, they’ve been ramping up over the past several quarters.

They operate on a simple premise: Borrow short-term debt (sometimes as short as overnight, but more commonly 30 or 90 days) to buy up a pool of very long-term assets – 30 year mortgages.

The model works well as long as borrowing costs are lower than the payouts from the mortgages they buy. But when the yields on three-month debt were suddenly paying more than 10-year notes in March, the equation flipped and it suddenly became more expensive for the REITs to borrow.

Stock prices for Annaly and AGNC took a sharp hit in April of about 13 percent and 10 percent, respectively, and both took another dive earlier this month.

A spokesperson for Two Harbors declined to comment, while representatives for Annaly and AGNC did not respond to requests for comment.

But on Annaly’s first-quarter earnings call in May, company president Kevin Keyes addressed the dividend. He said the company could maintain its dividend, but in order to do so it would have to increase leverage.

And with more uncertainty over the Federal Reserve’s future moves on interest rates, he said, that strategy seems too risky.

“This quarter’s reduction was really a function of frankly things we can’t control in the marketplace,” he said. “Long story short, we see a lot more risks in this market today than we have in the past couple of years, as it relates to generating that similar return.”