To say that 2013 was a bad year for many of the mortgage real estate investment trusts (REITs) would be putting it mildly. Even after you consider the MREITs generous double-digit dividend payments, the average firm in the sector still managed to lose about 3% for the year.

The culprit- rising interest rates and the Fed’s notion about ending it quantitative easing programs.

Yet, there could be some glimmers of hope and potential values brewing in the MREITs. Despite the fear of tapering, several factors are coming together and could help the sector deliver some hefty returns this year. In fact, some analysts expect the MREITs to outperform the broad market by 20% or so.

For investors, the time to tilt your portfolio towards the MREITs could be now.

Trading Below Book

For the MREITs, the Fed’s actions have real impact on their bottom lines. These firms basically loan money to owners of real estate or -more commonly- purchase existing mortgages or mortgage-backed securities (MBSs). Typically, MREITs will borrow money and then use that leverage to purchase these mortgage-backed securities. That leverage- along with what kind of MBS securities they own- often results in dividend yields north of 9%.

However, as short term interest rates rise, so do their borrowing costs. Ultimately, reducing dividend payments available to shareholders. This fact could help explain why the sector has felt such huge declines throughout 2013.

Yet those declines could be short lived.

First, the MREIT sector is trading below book value- something that hasn’t happened in quite a while. As investors have sold down the sector, the average mortgage REIT now trades at a 20% discount to the book value of its underlying bond portfolio. Historically, that sort of a discount is often followed by large returns as investors begin to snap up shares.

Secondly, rising interest rates may not be as much of problem as first realized. The Feds decrease in its QE programs is only designed to affect long term rates. Chairman Bernanke and his replacement Janet Yellen has promised to keep short term interest rates low until the economy gets back on surer footings- something that could take at least a year to materialize. That will keep profit margins quit fat at many of the MREITs. The difference between a 3-month T-Bill and 10-year Treasury note has almost never been wider in the last 35 years.

According to analysts at Keefe, Bruyette & Woods, these two factors should help the MREITs deliver total returns in excess of 20% this year as investors grab for yield once again.

Buying Some Exposure

With the possibility of making 20% during a period of relatively flat stock market gains, investors may consider adding a swath of the MREITs to a portfolio.

The easiest way is through the iShares FTSE NAREIT Mortgage ETF (NYSE:REM) spreads it’s nearly $1 billion in assets among 36 different MREITs- including industry stalwarts Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC). Over the last year, the ETF has pretty much matched the average return for the sector and fell around 2.47%. Today, REM sits near a 52-week lows.

However, that plunge could provide an interesting entry point for portfolios and allow investors to pick-up a monster 16.10% dividend yield. At the same time, the Market Vectors Mortgage REIT ETF (NASDAQ:MORT) can be used as another broad-play on the MREIT sector.

Yet, bigger values could be found in individual MREITS. An interesting buy could be Hatteras Financial (NYSE:HTS). According to the analysts at KBW, after Hatteras’s recent bumble this past year, the stock is now selling for an 18% discount to book value. The kicker is that much of HTS underlying investments are actually in adjustable rate mortgages. That means they are protected against rising rates. Even then HTS has hedged much of its exposure. With an 11.3% dividend, Hatteras’s could be a big win for investors.

Perhaps, the biggest gains can be had for those investors looking for more risk. The non-agency- i.e. not backed by the Federal government- MREITs have fallen harder over the last year and are trading at huge discounts to book value, along with supersized yields. Apollo Commercial Real Estate Finance (NYSE:ARI) focuses strictly on the commercial real estate space, as does Starwood Property Trust (NASDAQ:STWD). The two yield 9.6% and 6.5%, respectively. Meanwhile, Chimera Investment (NYSE:CIM) is currently trading a discount to book and yields 11.85%.

The Bottom Line

While the fear of rising rates has many mortgage REITs share prices singing the blues, those recent plunges do offer up some opportunities. For investors willing to add a little risk, the MREITs could be some of the biggest winners in the New Year. The previous picks- along with firms like AG Mortgage Investment Trust (NASDAQ:MITT) –make interesting selections in the space.

Disclosure- At the time of writing, the author did not own shares of any company mentioned in this article.

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