Ellington Residential: 11.6% return, trading at 0.81x book value (NYSE: EARN)
Despite my distaste for mortgage real estate investment trusts due to their sometimes unsustainable returns, I just added Ellington Residential Mortgage REIT (NYSE: WIN) to my dividend portfolio after the mREIT cut its dividend to $0.08 per share. The mortgage trust represents a 3% allocation in my portfolio, which makes it a rather minor holding.
Ellington Residential Mortgage REIT, like other mREITs in the first quarter, announced a significant decline in book value for 1Q-22, and management cut its monthly dividend payout by 20%. I made a purchase since the dividend had just been cut and the stock had started trading at a deeper discount to its book value.
Ellington Residential Mortgage REIT is now trading at a deep discount
Ellington Residential Mortgage REIT is an MREIT that invests primarily in agency residential mortgage-backed securities. Mortgage trusts are essentially investment companies that borrow short-term funds from lenders and invest in long-term mortgage-backed securities in hopes of earning margin on huge capital. Ellington Residential Mortgage Management LLC manages the mREIT on an outsourced basis.
As of March 31, 2022, Ellington Residential Mortgage REIT’s portfolio was invested in 15, 20 and 30 year fixed rate mortgages to generate interest income. Ellington Residential Mortgage REIT’s largest mortgage position is in 30-year mortgages, which represent 81% of the trust’s entire mortgage-backed securities portfolio based on fair value. The trust also invests in non-agency residential mortgage-backed securities (higher risk), but only a small percentage of its investment assets (1.5%).
Ellington Residential Mortgage REIT generates income from its extensive portfolio of mortgage-backed securities. Since the trust invests using borrowed funds, low funding costs are critical to mREIT’s performance and its ability to offer shareholders an attractive 11.6% dividend. If borrowing rates increase, spread net interest margins could contract, resulting in lower net interest income for Ellington Residential Mortgage REIT.
Ellington Residential Mortgage REIT received $5.4 million in net interest income in the first quarter, down 5.7% quarter-on-quarter. Due to the change in the central bank’s interest rate policy, the net interest margin of the trust fell from 1.81% in 4Q-22 to 1.76% in 1Q-22, a trend that we have seen in the broader mREIT market over the past few quarters.
To combat rising prices, the central bank is expected to begin an aggressive cycle of interest rate hikes in 2022, further raising lending rates. Higher funding costs will undoubtedly pose a challenge for investment firms that rely on cheap funding to make mortgage security investments in the future.
Dividend cut creates opportunity
The MREIT sector saw significant reductions in book value in the first quarter as monetary tightening and rising interest rates reduced mortgage-backed securities prices. The book value of Ellington Residential Mortgage REIT declined from $11.76 per share on December 31, 2021 to $10.14 per share on March 31, 2022, a decline of $1.62 per share (14%). By comparison, Annaly Capital Management’s book value fell $1.20 per share (15%) to $6.77 per share over the same period. Due to the change in interest rate forecasts for 2022 and the increased risk to book values, the book values of mREITs have declined significantly.
Many mortgage trusts, including Ellington Residential Mortgage REIT, have resumed operations at discounts to book value. The trust is currently trading at a 19% discount to its book value, which is higher than the discounts offered by Annaly Capital Management (NLY) and AGNC Investment Corp. (AGNC).
Ellington Residential Mortgage REIT also cut its monthly dividend by 20%, from $0.10 per share to $0.08 per share. On June 27, 2022, shareholders will receive a new dividend of $0.08 per share. Given that the mREIT has just reset its dividend payout due to rising interest rates, it is unlikely that the trust will have to cut its dividend again any time soon.
Why EARN Might See a Lower Stock Price
For mREITs like Ellington Residential Mortgage REIT, higher borrowing costs present substantial risk. A central bank dedicated to fighting inflation will shrink its balance sheet, raising interest rates. Higher borrowing costs due to this aggressive cycle of rising interest rates could result in lower net interest margins and net interest income for the Trust in 2022.
Ellington Residential Mortgage REIT lost a significant amount of book value in 1Q-22 and cut its payout, sending shares plummeting. Given that the discount to book value is currently 19%, the sale may have gone a bit too far. While rising interest rates indicate a risk to the net interest margin, the recent drop in the dividend indicates that the new dividend is more sustainable.