Mortgage REITs Breaking Out

By Matthew McCall | June 11, 2012 AAA

The housing market is still trying to dig itself out of the doldrums and many people feel that the bottom has not yet been reached. While this may be true for a large portion of the country, a related niche sector of stocks has been bucking the trend and outperforming.

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REM
The real estate investment trusts (REITs) that invest in residential and commercial mortgages and related products, have been outperforming the overall market and paying extremely high dividends. The iShares FTSE NAREIT Mortgage Index ETF (NYSE:REM) is up 12% year-to-date and currently has a 30-day SEC yield of 13.6%. Considering the 10-year Treasury yield is approximately 1.5%, the income paid out by REM is significant.

The ETF is made up of 28 REITs in the niche sector with the two largest holdings making up 40% of the entire allocation. Annaly Capital Management (NYSE:NLY) and American Capital Agency (Nasdaq:AGNC) each account for 20% of the ETF, making them major drivers of the value of the fund. Typically, an ETF that is heavily concentrated on a couple stocks is a red flag, but this is one situation due to the small amount of stocks in the sector, it can be ignored. However, investors must note that a big move in either of the top two positions can greatly affect the performance of the ETF.

An annual expense ratio of 0.48% is charged by the ETF, which for a niche sector ETF is acceptable. And another positive is the ETF's beta of 0.58 versus the S&P 500. The low reading shows little correlation between the overall U.S. stock market and the ETF, thus adding diversification to a typical portfolio.

SEE: Beta: Know The Risk

Individual REITs
NLY is performing as well as REM, with a gain of 4% in 2012, but it is outpacing the overall market and offers a dividend yield of 13.2%. The stock trades with a forward P/E ratio of 8.1 and a PEG ratio of 2.82. Technically, the stock has been trading in a narrow range for over a year and that is completely acceptable considering the high dividend yield.

AGNC has been strong in 2012, gaining 16% and recently trading at its best level ever. The stock pays out an annual dividend yield of 15.4%. The forward P/E ratio is a low 5.1, and a PEG ratio of 2.72. The stock has clearly been a leader in the sector and even a flat return over the next 12 months would be welcomed with the huge dividend yield.

Another stock in the top-10 holdings is Capstead Mortgage (NYSE:CMO), a fairly popular mortgage REIT in the sector. The stock is up 11% in 2012 and pays a 12.5% dividend yield. Similar to most of the stocks in the ETF, CMO invests in a basket of mortgage-related investments that continue to do well, despite a lackluster housing market.

SEE: How To Analyze Real Estate Investment Trusts

The Bottom Line
The two biggest concerns investors should consider when investing in REM are the heavy concentration into two stocks and the high dividend yield. The concentration can work in an investor's favor, as it has with AGNC, but could go the other way as well. The high dividend is a huge bonus for investors and makes the REITs attractive, however if the dividends are ever lowered, it could cause investors to flee rapidly.

At the time of writing, Matthew McCall did not own shares in any of the companies mentioned in this article.

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