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It's rare that I drift over to the mortgage REIT pages, but a recent article sparked my interest so I thought I would read it. The title of that article - Jim Cramer Is Just Plain Wrong About Annaly - was attention grabbing and after reading it, I thought it needed some comments beyond a few sentences, so here's my reply.

There are a few very basic things a REIT investor must be aware of and one of them is not to "forget about the taper-no-taper madness". Why? Because "forgetting the taper" is no small thing when the Federal Reserve has been the single largest buyer of mortgages and without their "bid", mortgages might not perform so well, creating mark-to-market losses on the existing portfolio - not to mention the consequential increase in rates which changed the prepayment picture on the mortgage portfolio.

What you do care about with the Fed is that they have a zero interest rate policy in place. This keeps shorter term interest rates between 0 and 0.3%, so Annaly Capital Management (NLY) will always be able to borrow cheap money. Borrowing cheap money is also dependent on repo financing and the price paid to borrow using mortgage collateral. While the fed funds rate (the only rate the Fed directly controls) is expected to be effectively zero in the near-term, repo financing and the availability to finance via the repo market is not guaranteed to be 0-30bps.

You now have the nuts and bolts of how mortgage REITs like Annaly operate. With the notable exception to their hedging strategy, which can be quite complicated and lead to counterintuitive results, there is no mention (in the author's article) of the various instruments that Annaly uses to hedge the interest rate risk of their portfolio. Can one have an understanding of these REITs without understanding the hedging taking place?

This is not to say that mortgage REITs cannot be understood, but one must understand that, like a bank, their financials only reflect one day in time and the portfolios are shifting, as are the hedging strategies and the amount of leverage employed. An understanding of these investments is essential, especially when one is confronted with the dual shock of the largest buyer "tapering" their purchases and rising rates.

Jim Cramer Is Right

Jim Cramer rightfully says that they are difficult to understand (note the word impossible is not used) as they are financial entities with REIT tax shells. Before one falls in with the "easy to understand" delusion, consider what the IMF had to say about mREITs (source: Bloomberg):

Regulators should boost oversight of the largest real-estate investment trusts that use borrowed money to invest in mortgage-backed securities because rising interest rates may push the firms into asset sales that destabilize markets, the International Monetary Fund said.

A version of that scenario occurred during the rise in rates that began in May, the IMF said. Repercussions might roil the REITs' lenders, disrupt the $5.3 trillion market in which they invest and damage the broader U.S. economy, according to its Global Financial Stability Report released today.

Further rate rises might "lead to a more destabilizing unwinding of positions," with a surge of 0.5 percentage point or more reducing the portfolio values at the biggest mortgage REITs "enough to generate at least temporary dislocations in the MBS market," the Washington-based group said.

The reliance by the industry on short-term loans to invest in government-backed mortgage securities with strategies involving interrelated risks mean their sales as prices decline might create a "fire sale 'risk spiral,'" according to the report.

Occam's Razor Explained

This is not to say that the mortgage REIT sector will implode as rates rise, but rather that the landscape has changed for the sector as for the first time in two decades, rates are not falling and the most recent buyer of the mortgage market (the Fed) and the two largest players in the market (Fannie Mae and Freddie Mac) shift focus.

Occam's Razor states generally that the simplest answer is the best answer until simplicity can be traded for greater explanatory power. Occam, however, is not known for his investing prowess but his philosophical prowess. In this vein, do not confuse the simplest explanation as the right one as it does not have the necessary explanatory power.

Now, as I mentioned, I rarely comment on mortgage REITs. It's not because I don't understand them but it has more to do with what Jim Cramer says - "They are complicated". Indeed, mortgage REITs are NOT FOR EVERYBODY and because of the volatility (driven by high leverage), the "kissing cousins" to equity REITs have proven to be highly speculative investments.

A year or so ago I put together a "pound for pound" comparison of the equity and mortgage REITs to demonstrate the reason I stay tuned into the more conservative asset class. To get a better understanding of the volatility, I thought I would provide this comparison again.

First, let's take a look at Total Returns for the period 1972 through 1980, during this time, equity REITs returned an average of 14.55% and mortgage REITs returned an average of 7.14%.

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Now, looking at the 80's (1980-1989), the equity REITs maintained a healthy margin with total returns (average) of 12.08% compared with 5.12% for the mortgage REIT sector.

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Now the 90's were arguably the best decade for mortgage REITs, especially 1995 and 1996 when the sector threw off an extraordinary 63% and 50% total return, respectively. However, even with these two record years, the equity REITs still managed to squeeze out better returns. During the decade, equity REITs returned 14.81% and mortgage REITs returned 9.56%.

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The 21st Century and the period of 2001 through 2010 could be argued as the decade in which mortgage REITs took off; however, one must consider the sensational year in 2001 when mortgage REITs returned over 77% and also, factor in the year 2008 when equity REITs had the lowest historical returns of -37.73%. If you remove the best year for mortgage REITs (2001) and the worst year for equity REITs (2008), the score would look like this: Equity REITs 19.3% and mortgage REITs 8.5%.

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Certainly May (2013) was ugly for all REIT investors; by taking a look at the chart below you can see that the summer was brutal for both equity and mortgage REITs. In May, equity REITs returned -5.93% and mortgage REITs returned -12.61. So far this year (through September), equity REITs have broken even and returned 4% and mortgage REITs are still in the dog house -.41% (thanks to the blistering in May).

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In reviewing the performance for 2011 through 2013 (September), we can see that equity REITs maintain a lead - equity REITs at 10.12% and mortgage REITs at 5.69%.

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To me, actions speak louder than words: mortgage REITs aren't for every investor and although there aren't that many REITs that I consider "buy and hold" alternatives, the facts are clear: Equity REITs are proven investments that deserve to be a core asset of every investor portfolio. Conversely, mortgage REITs are much more risky and should be considered only if you lack the knowledge and consider yourself a "market timer".

Protect Your Principal at All Costs

Now that I have provided you with some necessary "explanatory power" relative to the equity REIT sector, let's get down to business with a few investment opportunities. What better time to provide you with a list of the top dividend performers; not just the ones that never cut dividends, but the ones that have continued to increase their dividends - repeatedly - year-in and year-out. My fellow Seeking Alpha writer David Fish has an excellent resource, DRiP Investing Resource Center, that is frequently referenced to obtain the most current dividend data.

Note there are no mortgage REITs in the Dividend Champion (25 or more of straight higher dividends) or Dividend Contender (10-24 straight years of higher dividends) lists, another indicator of the extreme volatility in the mortgage REIT sector.

Most investors are attracted to the high-paying dividends of the REIT sector and because of the "forced" nature of the REIT model (REIT shareholders are legally entitled to 90% of the REIT's taxable income) they enjoy the more disciplined approach that in effect forces the REIT manager to payout substantially more income (to investors) and defend against "squandering or squirreling" it away. However, just because a REIT dividend appears too sustainable, be careful, for what you are really getting. The legendary investor Ben Graham summed up the quality of a repeatable dividend stream as follows:

One of the most persuasive tests of high-quality is an uninterrupted record of dividend payments going back over many years.

The following equity REITs are in a class differentiated by dividend consistency:

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Occam's logic prevails, that is, equity REITs are the simplest and most easily understood REITs and that is why there is strong likelihood that intelligent investors owning these "dividend aristocrats" will "sleep well at night" - the burden of proof is clear - by shaving off a few points of yield, an investor is likely to reduce his risk. As Occam's law suggests, one who starts with a complicated foundation for a theory (i.e. mortgage REITs) that potentially encompasses the universe, has a reduced chance of succeeding. So ask yourself, "Is the thrill of victory worth the agony of defeat?"

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Federal Realty (FRT) a dividend champion with 46 years of dividend repeatability is also the featured Blue Chip REIT in the October edition of my monthly newsletter, The Intelligent REIT Investor.

Source: SNL Financial, NAREIT, DRiP Investing Resource Center

REITs mentioned: (HCP), (UHT), (ESS), (NHI), (NNN), (OHI), (O), (SKT), (UBA), and (WPC).

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Source: Nothing Is Simple, Especially Mortgage REITs