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As yield hungry investors know, the current fixed income markets provide few opportunities for high yield returns without the need to pile on the risk. When looking at fixed income securities there are basically two approaches to increase yield:

  1. Go out deep on the yield curve.
  2. Move down the credit quality curve.

Go out deep on the yield curve and purchase JP Morgan Senior Notes 5.50% due 10/15/2040 and all you’ll get for the interest rate risk is a yield to maturity of about 5 3/8% . With an S&P rating of A+ it’s a relatively safe investment but, with 29 years to maturity, you’ll get hit hard if rates rise and you try to sell prior to maturity.

On the other hand you can close your nose and head down the credit curve. If you drive down this road, it would be wise to diversify by purchasing a mutual fund. As an example, the Fidelity High Income Fund (MUTF:SPHIX) has a yield of 6.92%. Just keep in mind that 93% of the portfolio is rated BB or less. If the economy takes a turn for the worse, default rates could increase and hit the portfolio hard.

Neither of these yields are anything to write home about for the risk level incurred. To put these low rates into a historical perspective, those who were getting 5.50% in a bank savings account back in the 1980’s would be ridiculed by those who discovered the much higher yielding, recently invented money market fund and they weren’t taking any risk as their accounts were insured by Uncle Sam! So whether you take on interest rate risk or credit risk, you’re still stuck with a rate below 7% and neither of these fixed income investments is secured directly by any collateral.

However, there may be another class of investments that seems to be overlooked by investors where the risk profile appears to be much more investor friendly. Ever consider a fully collateralized portfolio of loans backed by the hard assets of commercial real estate and managed by a well known and experienced money manager? How does a 9.7% dividend yield hit you without going out 30 years or sacrificing on credit quality?

In 2008 and 2009, as asset prices plummeted in the wake of the financial crisis, commercial real estate interest rates skyrocketed as banks, trying to simply survive, pulled in the reins on lending and limited their focus to dealing with the underwater loans already on their books. This opened up an opportunity for new money to step in and take advantage of the depressed commercial real estate loan market at very attractive terms. In 2009, three big name real estate managers floated new real estate funds to take advantage of the unprecedented turmoil in the commercial real estate financing space. Starwood Property Trust Inc. (NYSE:STWD) was first with an IPO on August 12th (pdf) that raised over $800,000,000. The following month, as the IPO market tightened, Apollo Commercial Real Estate Finance, Inc. (NYSE:ARI) raised about $200,000,000 and Colony Financial Inc. (NYSE:CLNY) raised about $250,000,000. The following table shows some of the comparative current data on these funds:

Ticker

Recent Dividend Yield

Recent Share Price

Recent Market Value per Share

(Discount)/Premium to Market Value

ARI

9.92%

$16.08

$17.76

(9.5%)

CLNY

6.98%

$18.25

$19.74

(7.5%)

STWD

8.08%

$21.67

$18.87

14.8%

One of the important considerations in my view is that all these REITs were formed AFTER the commercial real estate market imploded. This timing eliminates the risk that these REITS hold be any mismarked legacy investments that were purchased prior to massive decline in commercial real estate values. Also, in comparison to other investments like high yield bonds, the debt owned by these portfolios is fully collateralized by commercial real estate. Not at the generous terms that existed before the market crash but at much tougher post crash terms that are more beneficial to the lender. It should also be noted that these funds use leverage to boost portfolio yields and take advantage of TALF, the government backed program that provides cheap financing at very attractive terms to investors in AAA rated CMBS.

An investment in any or all of these three REITS may be good way to boost yield without incurring excessive interest rate or credit risk. For example, ARI, according to its pages 38 & 39 of its 12/31/10 10-K has a portfolio with a weighted average maturity of only 2.5 years and has 79% of its portfolio invested in AAA commercial mortgage backed securities. With a dividend yield of 9.92% and selling at a recent discount to fair value of 9.50% it certainly seems like an interesting alternative to most other fixed income investments that are available in a low interest rate world. Just understand that, like all REITs, the price of the stock may trade at discount or a premium to the true underlying value of the portfolio.

These are the personal views of Wall Street Titan. Investors should always do their own due diligence and never rely on anybody other than themselves for their investment decisions.

Source: Commercial Real Estate: Searching for Lower Risk, Higher Yield