As a dividend income investor, I know, and sometimes have been unhappily reminded of, the importance of diversification to manage risk and protect my income stream from disaster during bear market phases. Diversification at its most useful, should include having several different asset classes as well as several different company stocks within an asset class.
REITs are an asset class much favored by dividend income investors, because like MLPs they generally offer higher yields than "C" corporations. Of course, as is always true in any specific stock group, the yield can vary greatly with the individual company.
The REIT asset class comes in two distinct flavors: 1) The equity REIT, which buys real estate holdings, then collects rents for the company gross profit, from which, after expenses, the dividends are paid. 2) The mortgage REIT, which borrows money short term then buys long(er) term mortgages. The difference or interest rate "spread", between what it costs the mREIT to borrow short term and the higher interest rate it receives on the long term mortgage loan results in the companies gross profit. As is the case with the equity REIT, after deducting overhead/operating expenses, earnings are then available for dividends. Both types of REITs by IRS rules are "pass through entities" for tax purposes. This means the company pays no Federal taxes as long as they pay out to shareholders at least 90% of what their taxable income would have been. The shareholders then individually pay income tax on that portion of the dividend payment(s) that do not qualify as ROC (return of capital) under IRS rules.
IT'S DIFFERENT THIS TIME
Because the mREITs profit spread can change negatively whenever short/long term interest rates change even if only by a single basis point (a basis point, often called a "tick", equals 1/100 of one percent of interest), the potential threat to net profit is huge whenever interest rates rise or decline. The individual mREIT can go from a high dividend yield, to a declining dividend yield, to absolutely no dividend very quickly. Hence, the yields of mREIT companies are generally far higher than those of equity REITs, in part due to the large potential risk of a dividend cut or total elimination caused by the contraction of the mREITs interest rate spread. In a worst case scenario for an investor, bankruptcy ensues, and the shareholder's capital vanishes faster than a stage illusion by David Copperfield.
As a point of fact which is often misunderstood by average investors, it is not simply the change in interest rates that hurts the mREIT companies ability to pay the same/higher dividends, but rather any decrease in the interest rate spread between short/long loan rates. Those investors who suffered through an extended period of "agita" with mREIT holdings during the "Great Recession" of 2007-2009 can attest to the rapidity with which mREITs can go south. Unfortunately, as the saying goes "time heals all wounds," and with the Federal Reserve and its myriad "Tarp," "Terp," "Squelch," and "Wiggle" undulations of the last several years, the nasty memory of then has been replaced in many investor minds, by the complacency and the near zero rates/yields of now. This has precipitated an investor hunt for yield, often at any cost. The dangerous Mantra of "it's different this time" has again reared it's ugly head in many dividend income investor's minds. Well, I'll be 70 in August of 2014, and I've been through innumerable "differents" since I started investing in the early 60s. All those "differents" had one perfect miserable correlation; their unhappy ending.
iSHARES MORTGAGE REAL ESTATE CAPPED ETF (NYSEARCA:REM) TO THE RESCUE
In the remainder of this article, I will lay out how I believe the dividend income investor can use REM to participate in the high dividend yields of the mREIT space while at least partially protecting themselves from the potential disaster that would be caused by investing in the "wrong" individual mREIT. To be sure, this is not a panacea that will enable the investor to avoid all loss. REM, like all traded equities can decrease in price and it's dividend is not guaranteed to remain at any particular level. As famed financier, J. P. Morgan replied when he was asked what stocks might do in the future, "they will fluctuate." So will the price and dividend of REM. But REM can provide diversification within the larger mREIT group which can help protect the dividend income investor from a Chapter 11 cropper if they were to buy the wrong individual mREIT company.
Basic background: REM is an ETF (Exchange Traded Fund) and is made up of the stocks of a cross section of the entire mREIT universe. It seeks to track the investment results of an index composed of U.S. REITs that hold U.S. residential and commercial mortgages.
The creator of the REM ETF is BlackRock Inc. (NYSE:BLK), the massive asset manager whose financial products including ETFs have garnered superlative returns for many years. Approximately 35-40 mREIT/financial stocks are held in the REM portfolio at any one time. REM is slightly differentiated from other mREIT ETFs, such as the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT) in that REM can/does hold a portion of financial but non-mREIT assets. It's total mREIT holdings by percent of the ETF total vary, but are usually a minimum of 80% of the ETF. Most recently the REM holdings by percent of Market Value were broken down thusly: Mortgage REITs 82.67%, Mortgage Commercial Financing 12.54%, Diversified REITs 2.16%, Other/Undefined 2.11%, and Industrial & Office REITs 0.53%, see here.
As an ETF REM has a management fee of only .48%, which is a sizable advantage over closed end funds that focus on similar investments but whose fee schedule is much higher. Additionally, closed-end funds don't provide the narrow specific mREIT focus of an ETF like REM. Usually only 10 mREITs make up fully 60-70% of the entire holdings of REM. According to Yahoo Finance's REM top holdings page, the top ten REM positions and their percent of REM assets as of 7/10/14 are:
|Top 10 Holdings (67.92% of Total Assets)|
Naturally, this concentration and dependence on a relatively few names is a double edged sword. If the Black Rock professional mangers are not nimble enough to avoid/discard problem mREITs, especially in the top ten names, REM could suffer disproportionately. For the individual income investor to continue/complete their due diligence, a wealth of information is available on the specific holdings, financial metrics, and investment aims of REM on the REM page at Black Rock's site, here.
WHAT IS THE REM BEST USED FOR?
The aims of the dividend income investor in buying REM instead of an individual mREIT stock are three:
- To provide a high dividend yield. The dividend yield will be the total sum of the dividends REM receives from the stock holdings of the various mREITs in its portfolio after fund fees are deducted, divided by the number of outstanding shares of REM. The REM dividend will thus vary from quarter to quarter. Its size in any quarter will depend upon the amount of the dividend the individual mREITs declare, plus special dividends if any, multiplied by the number of shares REM holds in the various mREIT companies in the ETF. Additionally the mREIT companies respective ex-dividend dates will sometimes have a bearing on how much the REM dividend will total in any particular quarter. The possible REM dividend altering factors are ably discussed in SA contributor Lance Brofman's recent REM article found here.
- To provide diversification across a number of mREIT companies. Rather than the individual investor trying to choose the "best" mREIT from all that are available, the investor gets a carefully chosen basket of mREITs by Black Rock's professional money managers. In this case the saying, "there is safety in numbers" is particularly apt. This diversification and professional vetting provides protection for the REM investor. It keeps the investor from having to try to choose a single mREIT investment that subsequently makes some bad business decision(s) or gets blind sided in an unexpected adverse interest rate event.
- To allow the investor exposure to a REIT asset sub-class (mREITs) that is notorious for being hard to figure out on an individual stock basis, but which pays the dividend investor very handsome dividend yields.
HOW IS REM BEST USED?
I began to scale into my REM position @ $12.42 after reading Lance Brofman's article on SA that I referenced above. I then proceeded to do the remainder of my due diligence. I will continue purchasing REM until I have a full position (for me), aiming at an average price of $12.25 for a 9-10% yield at the annualized last dividend of $.292. In completing my due diligence, I found that there were a couple of good ways that the dividend income investor might approach an investment in REM to provide an extra "margin of safety." I chose to go the straight purchase route, but here are three suggestions that other dividend income investors might consider depending upon their appetite for risk, need for present day income, and fear of an imminent interest rate rise coupled with a sharp narrowing of the interest rate spread. This last possibility is the one that potential mREIT investors should fear most, if they are planning to buy an individual mREIT company for the juicy dividend. This is the "undifferent" ending that precludes a mREIT bear market debacle as mentioned above.
First, as I have done, the dividend income investor can pick a price where the resultant yield is high enough to make them happy to hold REM. I choose (hopefully) a blended $12.25, but since my first purchase was at $12.42, I may or may not ultimately achieve my goal. The yield of REM, on a trailing 12 months basis, is 13.57% computed on the recent close of $12.50. (Four quarters of dividends paid equaling $1.697 divided by $12.50). This was higher than comparable mREIT ETFs like MORT, due to the factors outlined in Lance Brofman's article. The annualized yield based on the same price is 9.34%. (Four quarterly dividends of the most recent $.292 which equals $1.168, divided by $12.50). I will be very happy with a 9-9.5% YOC (yield on cost), coupled with possibility of future upside dividend declaration surprises caused by mREIT special dividends or better than expected earnings in the larger holdings of REM.
A second option, especially useful to those dividend income investors that do not need to use their cash dividends immediately on payment, is to buy a partial REM position based on your individual investing parameters. Then enroll the shares in your brokers Automatic Dividend Reinvestment Program (ADRP). I have had my account(s) at Fidelity Investments for 35+ years. In addition to finding Fidelity's service very satisfactory, they allow you to set up a ADRP for any stock in your portfolio that pays a dividend. You can put stocks on or remove them from the plan at any time. This feature is a great tool in planning and managing your investment account(s). Information on Fidelity accounts and their investment policies is available here. I'm sure most brokers offer a similar feature. Call your brokerage customer service. Using this type of account feature, you can let your REM dividends fill out your full position. In this way, you will also benefit from DCA (dollar cost averaging) as well as having REM dividends fund part of your investment. Sort of having like having your cake and eating it too!
The third and last suggestion I have regarding buying REM involves using options. Option strategies can get very complicated and some strategies require the investor to provide margin or cash to boot, adding additional expense. I would keep it as simple and low cost as possible
The dividend income investor can buy REM, then write covered calls for the extra income you will receive in the form of the Call premium. Unfortunately there is no "free lunch" in the market, so option premiums on high yield stocks like REM are miniscule, unless the stock is right at the option "strike price" at the time the option is written. Therefore, for example, you would buy REM at say $12.50, wait until it rises to $13.00, then write the covered Call $13.00 strike price. The wait for these factors to align is not the downside. After all, you're going to be collecting dividends and amassing a paper capital gain while you're waiting. The potential downside, instead, occurs if REM rises over $13.00 during the option period and the buyer of the option "calls" the stock away from you. Sure, you pocket the option premium(s), all the dividends that have been paid, and the capital gain difference between $12.50 and $13.00; but you lose the REM stock position and your (presumably) fat YOC. Additionally, the investor also creates a taxable short or long term capital gain event if the REM position was held in a taxable account. If none of these downsides bothers you, then plan on doing a covered call write on your REM position if the opportunity presents itself. Personally, I prefer a Warren Buffett "forever" holding period on those dividend income positions I establish after having carefully done due diligence on them, but to each his own.
The last "wrinkle" in buying REM that the dividend income investor might consider also involves options. In this scenario, you buy REM shares then sell a REM covered Call option. Finally, you complete this strategy by taking the premium you received from the covered Call option sale and buy a REM Put option. A Put option, for the uninitiated, gives you the right to sell your REM shares to the writer of the Put option at the option strike price. The purchase of the Put option gives you insurance if a black swan event sends the prices of the mREIT group and/or the whole stock market into fee fall, thereby decimating the price of REM shares and its future dividends.
Here again there are two problems with this strategy.
First, as in the writing of the covered Call option discussed above, there is no premium to speak of on high yield stocks except right at the strike price. This is great for your insurance Put option buy as it equals a low Put option price that you'll be paying. However, it is terrible for your covered Call option premium as it also means a low option premium with which you hope to pay for your Put option insurance. If you wait, as discussed above in the example of covered Call writing, for REM to reach a strike price, for example $13.00, the premium from the written covered Call versus the cost of the purchased Put, both at a $13.00 strike price, should cancel each other out. However, that means that any REM price move over $13.00 will eventually result in your loss of the stock position, the high YOC that you have previously enjoyed, as well as creating a taxable event.
Second, you must find a way to finance the re-buying of the Put insurance option each time the Call/Put option period expires (generally 3, 6, or 9 months) or else lose the insurance part of the strategy. These problems can be solved to the investor's benefit by the use of advanced/complicated option strategies that are too involved to include in this article. I personally don't believe "the game is worth the candle" to try to employ these option strategies as they are time consuming to set up and monitor.
Further research into options and various strategies for the interested investor, can be found here for those who are interested in pursuing the topic.
Individual investor must decide for themselves which, if any, of the three proposals outlined above are appropriate for their investing style. As I have stated, I preferred the straight forward approach; research REM as a dividend income stock/diversification candidate, set a target buy/average price after full due diligence convinced me that REM met my needs/investment standards, and finally buy a partial REM position and plan to scale into a full position as close to my predetermined buy/average as possible. Hopefully, this article has shown SA dividend income investors why they might also agree that they want to buy REM to gain exposure to the mREIT asset class and its high dividend yield. Now it is up to each individual to make the final call for their portfolio.
Disclaimer: The information I have provided is not meant to be investment advice, nor is it guaranteed in any way to assure success in REM or any other stock/ETF. Individual investors need to make their own choices based on further due diligence & their particular investment needs.
Disclosure: The author is long REM. 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.