REIT Payout Cuts Spurred by Fed Taper That Hasn’t Come

Steven Hoffman, owner of a wooden button factory in Brooklyn, New York, was drawn into real estate investment trust CYS Investment Inc. by its 12 percent dividend yield. After buying 2,000 of shares a year ago that have since dropped more than 43 percent amid concern the Federal Reserve would reduce its economic stimulus, he’s now anxious his payout will be cut.

“I’m pretty upset that CYS has gotten so upside down,” said Hoffman, 64, adding that he tracks the stock daily to decide whether he’ll hold or sell his stake.

Mortgage REITs, which attracted retail investors like Hoffman with double-digit yields amid record-low interest rates, plunged 18 percent since May 14 as government-backed mortgage bonds endured the longest monthly losing streak since 1999. Amid the rout, the companies shifted to more defensive strategies, reducing the potential for future earnings that are used to pay dividends. Their actions proved to be premature after the U.S. central bank last month unexpectedly held off on slowing its $85 billion in monthly bond buying.

At least 10 of the firms cut third-quarter payouts, including Annaly Capital Management Inc., the largest, American Capital Agency Corp. and Apollo Residential Mortgage Inc. Retail investors, who make up a high percentage of mortgage REIT shareholders, could be more likely to sell after the reductions, said Christopher Donat, an analyst at New York-based Sandler O’Neill & Partners LP.

Retail Investors

More than half of American Capital Agency owners are retail, according to Donat. For Armour Residential REIT Inc., which reduced its monthly dividend by 29 percent and has sold almost a quarter of its holdings since the end of June, the retail base is almost 70 percent and for CYS it’s more than a third.

“In the past few years there was this quest for yield among retail investors so they got more into newer agency mortgage REITs such as Armour and American Capital,” said Donat, who has a sell rating on the two companies’ shares. “If those investors start selling mortgage REITs, institutions might be worried there’s more retail selling to come and not take up the slack.”

Hoffman, a Long Island, New York native, became more involved in investing during the past decade as the button manufacturing business his father started in 1939 shrunk. He was attracted to REITs including CYS and Annaly last year as the firms were paying dividends almost twice the average yield on company junk bonds.

Annaly Returns

Hoffman held Annaly for two month-long periods last year and bought CYS in September 2012 after the stock gained 71 percent in the previous three years, including reinvested dividends, outperforming a Bloomberg index of mortgage REITs that increased 63 percent in the same period.

The purchase came a week before the Fed started its latest round of buying home-loan securities and Treasuries to bring down borrowing costs. The central bank’s purchases also drove down yields on new bonds bought by mortgage REITs and increased homeowner refinancing, reducing their profits.

The shares took another hit in May when the Fed signaled it was weighing when to reduce purchases.

“Investors didn’t anticipate asset prices to weaken as quickly as they did,” said Daniel Furtado, an analyst at Jefferies Group LLC. “People were parked in these assets thinking the economy was still just trudging along.”

Lower Payouts

CYS, based in Waltham, Massachusetts and run by former Fidelity Investments bond manager Kevin Grant, last month maintained its quarterly dividend of 34 cents, for an annual yield of 17 percent. Still, investment bank JMP Securities LLC predicts a lower payout this quarter after the firm reduced its assets by 15 percent from May through June. Representatives from CYS didn’t respond to telephone messages seeking comment on the company’s strategy and payouts.

CYS’s dividend payments have reduced Hoffman’s loss to 27 percent from 44 percent. Hoffman said he may sell the REIT if he can find another investment that pays a high yield. The stock decreased 1.2 percent to $8.17 today in New York.

“Before I make a move out of something I have to have something to put it into, and there isn’t much I find out there attractive in dividend land,” Hoffman said.

Annaly already dropped its quarterly payout 13 percent to 35 cents last month; American Capital reduced by its dividend by 24 percent to 80 cents and Apollo Residential by 43 percent to 40 cents. Spokesmen for the companies declined to comment.

Overly Conservative

Some management teams were overly conservative and cut more than they needed to, according to Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc.

“The dividends will be partly restored in the next year, not fully, that will take longer,” she said.

Mortgage REITs used several strategies to prepare for the Fed’s potential retreat, including reducing their use of borrowed money, increasing interest-rate hedges, shifting to shorter-term bonds and adding to cash reserves.

American Capital Agency shifted its portfolio toward 15-year mortgage securities from 30-year debt in the second quarter, President Gary Kain said on a conference call in July. It also reduced investments to limit the increase in its leverage to 8.5 times, from 8.1, as the falling value of its holdings eroded shareholder equity, he said. When markets stabilize, it could add more leverage, he said.

“Over time, this could be a very good environment but right now we’re sort of playing defense,” he said. The REIT has declined 10 percent this year including reinvested dividends.

Hedging Costs

Two Harbors Investment Corp., based in Minnetonka, Minnesota, added derivatives to protect it against rising interest rates. The cost of the hedges reduces earnings. The REIT, which cut its dividend by 9.7 percent, has returned 2.3 percent this year.

“When there’s a time of great volatility and high uncertainty, one of the key things to do in our mind is to protect book value,” Chief Investment Officer Bill Roth said Sept. 10 at a conference. “Because our ability to pay dividends over the years to come is driven largely by how much capital we have and if our capital base is deteriorated or eroded, our ability to pay future dividends goes down.”

After the REITs prepared for a rise in rates, the rates fell. A Bloomberg index of yields on benchmark Fannie Mae 30-year securities dropped yesterday to 3.30 percent, after rising to 3.81 percent on Sept. 5 from 2.28 percent in May as speculation grew that the Fed would pare its debt purchases.

Future Earnings

A measure of spreads against Treasuries has erased much of its gains since then. Yields on the securities fell yesterday to

1.30 percentage point higher than an average of five- and 10-year Treasury rates, after climbing to as high as 1.51 in July from 1.14 percent in May. The current levels are lower than the

1.54 percent average since the start of 2000.

Mortgage REITs’ use of interest-rate hedges means the value of their holdings and future earnings depend on both spreads and yields, as well as their borrowing costs, which are tied to short-term interest rates.

After the spreads narrowed following the Fed’s decision, potential returns on the debt “aren’t quite as attractive as they were,” said Invesco Mortgage Capital Inc. Chief Executive Officer Richard King said Oct. 1 at a conference.

Adjustments to Invesco Mortgage Capital’s strategy during the “real-life stress test” of soaring bond yields included less use of borrowed money, additional hedges against rising rates and purchases of securities backed by adjustable mortgages with a few years of fixed rates, he said. Protecting its book value, or the net value of its holdings, remains “front and center” in executives’ mind, he said.

Along with boosting bond values by holding off on tapering its purchases, the Fed last month pushed back expectations for how soon it will raise a rate target that guides mortgage REIT borrowing costs, potentially holding them near zero for longer.

REIT managers “still say investing in bonds supported by mortgage payments is a great way to create value over time,” said Ross of Wunderlich. “The Fed will stand its course and REITs can make money when the Fed withdraws, but the volatility surrounding that might be painful.”