Though investors still tend to interchange references to traditional brick and mortar REITs with mortgage REITs, or mREITs, there should be no confusion over the vast operational differences between the two. The former almost exclusively owns property while the latter typically invests only in mortgage backed securities, usually residential.
Due to the variances in business line complexity, leverage profiles, and considerable yield point differentials that can be found in the two, usually between 3-6% for traditional REITs and typically double digits for mREITs, one is generally deemed to be taking on much more risk when purchasing an mREIT. But is that really the case?
Different Risk Profiles
Last year presented investors with the potential price volatility inherent in both kinds of REITs. The Fed's move to taper its bond buying stimulus - and subsequent interest rate gyration - caused a widespread sell off in virtually all REIT shares. The 2013 collapse of Realty Income (NYSE:O) and American Capital Agency (NASDAQ:AGNC), two respective REIT/mREIT bellwethers, can be clearly seen in the below chart.
O/AGNC - 2 Years
But while the rate volatility had profound impact on both companies' stock prices, it really only affected American Capital Agency's operations. AGNC's book value dropped sharply during the course of the year (~17%) as did the company's dividend (~48%).
Source: AGNC IR
While AGNC's stock tanked better than 40% during 2013, most of the drop can be explained by its irrational trading around book value. It was trading almost 15% above book before the May meltdown and by the end of the year it was about 25% below book. Over the course of this year, the discount has narrowed substantially to about 6 percent. The stock now yields a little over 11% on an annualized yield of $2.60 a share.
By comparison it was business as usual during the rate kerfuffle at Realty Income, an owner of standalone properties leased on a triple-net basis to mostly investment grade clientele. No operational hiccup, no dividend interruption. Though investors seem convinced that a higher rate environment, through mainly increased cost of capital, will be a negative force on many equity REITs, it's difficult to say what the effect will be. I would suggest that REITs with cleaner/leaner balance sheets and shorter-term lease deals may perform much better than those with higher leverage and longer-term deals. Of course there's always that possibility that rates don't go up or we continue through a relative economic malaise.
In any case, Realty Income's stock dropped last year based on irrational valuation prior to the Fed's announcement and the perception that it is a bond market proxy, not because its operations were dramatically affected. With latest dealings of $45 a share, the stock yields about 5 percent.
Steady Eddie Versus Wobbly Robbie
When you look at the two general business models, you see one with plenty of recurring revenue and ongoing simplicity, versus one with a lot of quarter to quarter noise, leverage and comparably convoluted inner workings. Of course on an income level, one is generally handsomely rewarded, comparatively speaking, for accepting the less definitive nature of the mREIT.
So the question for prospective investors becomes whether they should settle for the "dependable," yet lower yield range found in a more traditional REIT or stretch for the more robust - and erratic - payouts of an mREIT.
Many investors look at mREITs as speculative and risky. While they should be viewed as potentially extremely volatile - both on an invested capital and yield perspective - and highly interest rate sensitive, I'm not sure I agree with the speculative designation. These companies are investing in mortgages, residential and commercial, that generate real cash flows.
But they borrow heavily, are dependent on a stable spread to achieve their inflated yields, are subject to prepayments, and other variables that traditional REITs are not. So the revenue side of the business is generally not speculative given very tangible and generally low credit risk cash flow sources (agency RMBS). However, when you lever up by a tremendous amount and are dependent on capital markets and spread stability to function properly, you create symmetric incremental potential for capital and income instability in the event of interest rate gyration.
Traditional REITs should not be viewed as necessarily safe havens either. During the financial meltdown five years ago, many of them were on the ropes as access to capital dried up and their very survival was questioned. Simon Property (NYSE:SPG), the nation's largest mall owner, saw its stock price plummet and second largest mall owner General Growth (NYSE:GGP) was forced into bankruptcy.
SPG - one decade GGP - one decade
Rate Risk And Economic Recovery Speculation
I think it is extremely difficult to paint wide ranging forward assumptions across either traditional or mREITs due to the varying lines of building ownership and asset portfolio structures that each maintain, respectively.
Storage sector REITs, for example, which have generally shorter-term, widely fluctuating rate relationships with tenants would seem to have economic recovery advantage over triple-net REITs that usually maintain longer-term, structured lease contracts . As a further differentiator, even REITs in a similar operating space may have different individual leverage profiles with varying costs of capital and potentially opposing general acquisition and/or growth strategies.
As I have oft written about in the past, two commercial triple nets - Realty Income and American Realty Capital Properties (ARCP) are being viewed (and priced) quite differently by the market. As one is considering an equity REIT, business line and underlying lease contract type, leverage profile, operating payout percentage, and general management style should all be factored into the analysis mix.
On the mREIT side, while there are also a slew of performance differentiators, given the wide latitude in which they are utilized by the various managements, underlying portfolio performance as measured by book may vary dramatically. The amount of leverage exposure, the types and duration of instruments that are being used (agency/non-agency RMBS or commercial), and the amount of hedging will all factor prominently into ongoing book value as well as quarterly income. While the comparison may be simplistic, at the end of the day mREITs are really mortgage-centric closed-end bond funds operated and managed in a much more highly levered, complex environment than a traditional CEF is.
On a general level, although I don't necessarily agree with the notion that mREITs are speculative, they are exceptionally interest rate sensitive, inherently volatile, and not for the risk averse. On the one hand you are rewarded with yield, on the other hand you are somewhat blinded to quarter-to-quarter book value, income generation and dividend payment.
With traditional REITs, while there is certainly operational risk in a rising cost of capital situation, income and underlying asset values are much more secure and predictable, barring another financial meltdown or significant real estate market move.
Six months ago, when mREITs were trading at robust discounts to book, the risk/reward profile seemed favorable to aggressive income investors. Today, priced closer to book, I would opine that they no longer appear that attractive. While I took a small, tactical position in REM - the iShares ETF - at the beginning of this year, I'm in no rush to extend my limited exposure to the group.
Meanwhile, I think traditional REITs are appropriate for a much wider range of income investors, at a much higher potential portfolio allocation percentage. But with the group up 15% YTD, as measured by IYR - the iShares U.S. REIT Index - they shouldn't be collectively viewed as values either. Part of this year's gain probably represents retracement from late last year's oversold conditions, and part of it represents this year's pullback in the 10-year Treasury. Operations, by and large, continue to be stable, but not particularly robust on a wholesale level.
Though many of the equity REITs I've written about in the past are looking fully valued today, I'd still recommend those with attractive FFO valuations and limited expectations. That leads me back to controversial American Realty at 11X this year's AFFO and 8% yield point, which has admittedly been one of my worst recommendations, but one I'm sticking with, and Lexington (NYSE:LXP) Properties, which sells for an even lower multiple and a bit better than 6% yield point.
For those with an itch or a yield need to buy mREITs, I don't think I'd scratch too hard and would probably stick with a diversified play like REM. For those that like to live life in the fast lane or need even higher yield, there's MORL, a 2X levered ETN that tracks a basket of mREITs.
Like many other areas of the market, deep value in the REIT/mREIT space is becoming increasingly harder to find. Buyers today should be particularly cognizant of the rate environment, and mREIT buyers, especially, may be wise to consider protective hedges to guard against further unforeseen capital volatility.
Disclosure: The author is long REM, ARCP, LXP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.