Build An Intelligent REIT Portfolio Without Mortgage REIT Risk

by: Brad Thomas

Last year I wrote an article (Balancing Risk: REITs That Outperform in Good Times and Bad) in which I explained the use of leverage and its correlation with the higher risk REIT alternatives known as mortgage REITs:

As in any form of investment, the more debt you use, the greater the potential for gain or loss. When we buy stocks on margin, we are leveraging investment returns with debt. And any asset carried on high margin involves substantial risk, since a decline in the asset's value will cause a much larger decline in the original investment (principal).

Likewise, REITs that use excessive leverage to increase returns do not provide long-term value (except during extraordinary periods when commercial real estate is acquired at abnormally cheap prices) and those REITs that generate the most consistency are distinguished by modest debt and conservative balance sheet fundamentals.

It is well known that mortgage REITs own debt, instead of property, and the risks of investing in mortgage REITs are considerably elevated, as compared with other dividend paying stocks. That is, mortgage REITs benefit when interest rates come down and that increases the value of the mortgages.

Essentially, it is the beneficial use of borrowing money that magnifies returns (leverage) and that is the reason that spreads for mortgage REITs are wider and dividends are much higher (than equity REITs). To put in bluntly, as I have often argued, MORTGAGE REITs DO NOT BELONG IN A RETIREMENT PORTFOLIO. Here's why?

The Elusive High Yielding Dividend REITs

According to NAREIT, there are 131 equity REITs and 28 mortgage REITs. By definition, both are considered REITs but the comparisons stop there.

On average, a $1,000 investment in all Equity REITs in the beginning of 2012 would have returned a total of $1,970 while the same amount invested in all Mortgage REITs would have returned $1,989. So one would ask, with more risk, why did mortgage REITs not return much more? To answer that question, let's take a look at a few well-known mortgage REITs.

Annaly Capital (NYSE:NLY), a prolific mortgage REIT, has certainly had its ups and downs. As Regarded Solutions explained in a recent article (Annaly: Getting Lulled Into A False Sense Of Security):

With the Federal Reserve basically calling the shots in these areas, the potential for profits are greatly diminished for NLY and other companies in the agency backed MBS sector. Diminished profitability will mean more dividend cuts in the near to medium term from what I can tell. If dividends are cut then total returns on an already risk-oriented sector to begin with, could mean that the share price will continue the downward trend we have seen since the Fed announced the latest actions.

Annaly, with a $14.41 billion market cap, has returned a modest 3.25% in 2012 and the dividend yield fell over 16% last year (in 2012) and 7.9% in 2011.

Taking a closer look at Annaly's dividend yield that fell from around 14% a year ago to around 12.18% today - a decrease of 13.15%.

Take another well followed mortgage REIT, American Capital Agency (NASDAQ:AGNC) with a market cap of around $10.75 billion. With a current dividend yield of 15.88%, the mREIT reduced its dividends paid by around 11% in 2012 while the company returned 29.17% in all of 2012.

American Capital was yielding just under 20% a year ago; however, a 19.34% decline in income since then resulted in a current dividend yield of 15.88% today.

Let's take one final example: Armour Residential (NYSE:ARR), with a current market cap of $2.139 billion returned 15.98% in 2012. Some like this mREIT because it pays monthly, however, the comparisons to "The Monthly Dividend Company", Realty Income (NYSE:O), stop there.

Armour has a current dividend yield of 13.87% but the dividends paid fell over 17.5% in 2012. In fact, Armour's yield dropped from just below 19% in early 2012 to a yield today of 13.87% - that is a 26.01% drop. Ouch.

Do Mortgage REITs Belong in a Retirement Portfolio?

Recently I was reading a great (and short) book called The Little Book That Still Saves Your Assets by David Darst. In the opening Darst explains the value proposition for intelligent asset allocation:

For centuries, fortunes have been made, preserved, or lost because people either paid careful attention to, or ignored, the main tents of asset allocation. From Joseph in the Old Testament, through the Greeks, the Romans, the Venetians, the Spanish, and others, to the great banking fortunes of the Barings and the Rothschilds, and up to the Modern Era - Astor, Rockefeller, Carnegie, DuPont, and now Brin, Page, Allen, Walton, Ellison, Adelson, Zuckerberg, Gates, and Buffett, money has been created through concentration, and then compounded, accumulated, and retained by following the key ideas of asset allocation: diversification, rebalancing, risk management, and reinvestment. By the same token, mighty empires have fallen and fortunes have withered away when families and nations have left themselves get too concentrated in one kind of asset and thus far too exposed to risk.

The purpose for this article is to demonstrate to readers that mortgage REITs DO NOT belong in a retirement asset allocation model. I am not advocating that mortgage REITs don't serve a place in an investor's portfolio - because they may - I am simply making the argument that mortgage REITs are highly volatile and offer little in terms of diversification making the investment class highly speculative.

Clearly high dividend yields have been the driving force behind mortgage REITs. I am sure many have been tempted to stick their toe in the fountain of youth in hopes of creating wealth and substantial disposable income. Since mortgage REITs are in fact REITs, many investors get lulled into the temptation by their mere association of their cousin equity REITs. More simply said, some investors simply chase the highest yielding REITs as part of an overall asset allocation theory in hoping that the returns outweigh the risks in the long run. Believe me, they won't.

In David Darst's book (mentioned above), he explains that most successful people have turned to people for advice and insight in selecting stocks. Darst explains that everyone needs a mentor - or as Darst suggests an "Uncle Frank" - to help them by providing mental and emotional support in difficult decision making.

As most know, my writing platform is The Intelligent REIT Investor so some of you know who I turn to for the cold, hard facts on sound stock selection. Of course, I'm not able to gain advise from my mentor, Ben Graham, in person so I also turn to others like Warren Buffett, Donald Trump, and Milton Cooper (Copper is a co-founder and Chairman of Kimco (NYSE:KIM)). Others I have turned to on Seeking Alpha include Chuck Carnevale, David Fish, and David Van Knapp - all most knowledgeable in their field and who I deem gifted and intelligent investors (and writers).

I hope that for some investors I can become the "Uncle Frank" and provide you with a clear harbinger that mortgage REITs are full of risk or as I wrote in a previous article - Recognizing REIT Risk - That Raised Nail Gets Hammered. Darst explained risk assessment best in The Little Book That Still Saves Your Assets:

One of the key reasons you rely on an outside person in asset allocation ad investment matters is to help you separate the signal from the noise in all the short-term and long-term information that comes your way from the worlds of finance, economics, and politics. Sometimes, a conversation with your Uncle Frank can help you make judgments about what is really happening. You should seek Uncle Frank's views and viewpoints to heighten and focus your curiosity about cause-and-effect relationships and how things work in the world. Another insight your Uncle Frank can help you with is knowing the difference between luck and skill in your investment successes.

Darst when on to explain,

As a trusted outsider, Uncle Frank can help you develop the patience, calm, and reason you need to achieve success with your decisions.

Beware! What Goes Up Must Come Down

When you are referring to mortgage REIT risk, my "Uncle Frank" - Ben Graham - would have explained it best:

We all know that if we follow the speculative crowd we are going to lose money in the long run.

After all, Warren Buffett even preaches the subject and I often cite his famous words:

Rule No.1 is never lose money. Rule No.2 is never forget rule number one.

So let's take a hard look at the mortgage REITs and see how sustainable the sector has performed over time…starting with dividend yield…over the last 6 years the mortgage REIT dividend have averaged 13.5%...not bad:

But what about total returns? Let's see how the combined impact of dividends and capital appreciation has impacted an intelligent asset allocation portfolio. We all know 2012 was a good year for mortgage REITs, but what about the previous few years?

Ouch. The average total return for mortgage REITs over the last six year period was -1.5%. So even with the high dividend yields (averaged 13.5%), the principal of the shares fell or as my mentor, Ben Graham, would say:

An investment operation is one which, upon thorough analysis, promises safety of principal and satisfactory return. Operations not meeting these requirements are speculative.

But now let's turn to the more intelligent REIT class known as equity REITs. Compared with the mortgage REITs, the dividend yields are not as high:

Over the last 6 years, equity REIT dividend yield have averaged 4.56%; however, "Uncle Frank" (Ben Graham) has taught me that the key to a sustainable asset allocation model is to own shares that have repeatable sources of income. Albert Einstein is also widely rumored to have said that:

the most powerful force in the universe is compound interest.

Einstein (another "Uncle Frank" character) is also credited with discovering the compound interest of Rule 72 and was documented to have said something almost as compelling, that:

it is the greatest mathematical discovery of all time.

So now let's see what happens when we look at the power of compounding (dividends) and the total returns of the equity REIT sector.

So equity REITs returned an average of 4.8% over the last 6 year period (compared with -1.5% or mortgage REITs). However, let's remove the Great Recession time frame and compare the returns generated during the "recovery period" (2009-2012). Here is what we see:

So even when we remove the results from The Great Recession we can see that equity REITs led the way with average total return performance of 20.6% while mortgage REITs returned 16.2%.

Let's now compare "apples to apples", Annaly and the blue-chip performer, Realty Income.

Wow. What a clear picture demonstrating the "power of repeatability". Realty Income returned over 379% over the last 10 years while Annaly returned almost one-third of that, or 135%.

In a previous article (Cap Rate Compression: A Harbinger Forming for REIT Investors) I wrote,

It appears that there is little sign that interest rates will rise significantly in the near term. That is why valuations of REITs may appear to be expensive relative to historical standards. The current low interest environment, at least in part, justifies the higher valuations, as does the lack of income options from the bond market.

However, as cycles shift - perhaps in two, three, five, or 10 years - this trend will almost certainly reverse and rising rates will become a hindrance to growth for a wide range of different stocks, including REITs.

REIT Investors BEWARE. We both know that equity REITs and mortgage REITs are subject to rising interest rate risk; however, mortgage REITs are more likely to sustain loss. Why?

Given the facts that any rise in interest rates will reduce spreads (short-term rates tend to rise faster than long-term rates) book values will fall (higher long-term rates cause the book value of the portfolio to be marked down) and investors will lose money. That's a fact.

Take a look at the last big mark-down period. During the last rising rate cycle (2003-2005), short-term interest rates rose and the yield curve went negative - alas, mortgage REITs went in the ditch. During that period, yields went from 15% to 4% (dividend cuts) and total returns, in the same period, were around negative 30%.

From one Uncle Frank to another, protect your principal AT ALL COSTS. David Darst (in his book referenced above) hit the nail on the head, when he wrote:

RUINATION. There is just no way to make it sound nice, is there? In addition to its connotations of chaos and catastrophe, in the here and now, ruin describes disorder, confusion, and any condition that causes torment or misery. In asset allocation and investment decision making, several key mistakes can lead us down a nearly certain path toward investment ruin.

Darst puts the notion of tough decision making to the test when he wrote:

Assuming that a good investment will be good forever is usually a sure ticket to despair. It is never wise to assume that just because a particular asset or fund is doing well, it will continue to do so. There is an ecological cycle to most investment classes. Just as a forest grows you crowded with life and growth, leading to inevitable forest fire, at some point investments and asset classes become too crowded with investors and the profit potential diminishes.

Finally, and this is most relevant to mortgage REITs today, as Darst explains:

It is crucially important not to let yourself get carried away by greed. A desire to make as much money as possible right now leads us to make overly risky investment decisions. It can cause us to set our well constructed plans and abandon our principles and become short-sighted and reckless. When we become controlled by greed, we tend to lose touch with the voices of reason and the temperature nature needed to achieve our dreams.

If you ever read a mortgage REIT article on Seeking Alpha, I hope it is this one. Remember, recognizing risk is absolutely essential to investing and don't get carried away with the temptation for high returns and lose sight of the number one goal of PRINCIPAL PRESERVATION.

Before you go out and buy mortgage REITs for their high yields, consider the safer and more durable equity REITs. Take a look at the three articles I wrote last week: some blue-chip REITs (here), some attractive fairly priced REITs (here), and some newly listed REITs (here). Here is a snapshot of the durable dozen:

In closing, Howard Marks (another "Uncle Fred") explained the concept of intelligent investing in his exceptional book, The Most Important Thing:

Risk control lies at the core of defensive investing. Rather than just trying to do the right thing, the defensive investor places a heavy emphasis on not doing the wrong thing. Because ensuring the ability to survive under adverse circumstances is incompatible with maximizing returns in good times, investors must decide what balance to strike between the two. The defensive investor chooses to emphasize the former.

Source: SNL Financial and NAREIT.


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.