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Low interest rates are not the only thing that determines the fate of REITs. They depend on functioning capital markets to stay afloat.

REITs borrow at low short-term rates and make long-term investments in higher-yield assets. Thus Fed’s commitment to keep the Fed Fund Rate at nil for another two years will keep a lid on borrowing costs for REITs and sweeten up their yields. But borrowing short-term debts to support long term assets also means that REITs need to keep rolling over their debts. There were times when capital markets simply ceased to work and even the most creditworthy companies couldn’t issue new debt to retire existing ones. No matter how low the interest rate was, capital was simply on strike. If this happens again, REITs with the highest leverage ratio will be the first to belly up.

Not too far back in history have we experienced such a perfect financial storm.

In Nov, 2008, the Fed lowered the Fed Fund Rate to a then 50-year low at 1%, but still the financial market was seized up. As reported in a news report dated back to that time, Fitch’s managing director Steven Marks commented “several REITs that we rate — and several that we don’t — depend on functioning capital markets to fund their businesses, and right now, the capital markets are not functioning.”

The most difficult debts are unsecured ones since they are not backed by properties, Mark continued. “The REIT unsecured debt market is effectively closed right now — even the highest-rated names can’t issue unsecured debt on economic terms.”

Consequences of not being able to roll over debts are devastating. Even if a REIT manages to avoid bankruptcy, it may have to sell asset at a fire sale price to meet debt obligations. Not only its stock price will crash, but also its future payout will collapse as fewer assets generate less income – a neat one-two punch.

Kite Realty (KRG), a REIT identified at risk back to 2008, saw its stock price dropping from above $10 to around $3 in less than two months. Its quarterly dividend also dropped from 20 cents per share to 6 cents per share. Three years later, its stock price and dividend are still lingering around the same levels.

Arguably 2008 was an extremely rare case. The 2008 crisis was on a par with the Depression and people may say that it doesn't happen often. But after the Fed completed two rounds of QE and the economy still appears in the woods, we are likely to slip back to the same nightmare again.

The most reputable companies are still able to borrow. Walt Disney sold $1.85 billion of debt Thursday at favorable terms. But that doesn’t necessarily mean that an average company can borrow freely at similar terms. When outlook is dark, the capital market is notoriously lopsided toward the most prestigious companies, while shutting its door to the rest.

What’s happening now in the mortgage market is alarming. Although mortgage rates hit a 50-year low, that still failed to stimulate any home purchasing. Thursday the number was out that July’s existing home sales dropped 3.5% from June and fell to their lowest level of the year. The reason, according to economist Joel Naroff, is that “only the best borrowers are getting mortgages and that is not enough to drive the market forward.” If the same happens in the capital market, REIT investors will feel the same pain as back in 2008.

We suggest investors to take a close look at leverage ratios of REITs. Because a high yield is often a result of a high leverage ratio, blindly embracing a REIT with the highest yield wouldn’t be a good idea. In the table below we list the REITs with the highest yields, together with its total debt-to-equity ratio as a proxy to the leverage ratio.

REIT

Dividend Yield

Total Debt / Equity

Rank

Invesco Mortgage Capital (IVR)

23.19%

0

39

American Capital Agency (AGNC)

19.13%

7.09

12

Resource Capital (RSO)

18.55%

3.4

15

Cypress Sharpridge Investments, Inc. (CYS)

18.31%

0

18

Chimera Investment (CIM)

17.11%

1.89

15

Hatteras Financial Corp (HTS)

14.55%

7.43

13

Annaly Capital (NLY)

14.36%

5.69

78

Anworth Mortgage (ANH)

14.27%

0.04

27

MFA Mortgage Investments (MFA)

13.55%

3.24

13

Getty Realty Corp (GTY)

11.48%

0.43

17

Also listed in the table are their ranks from our ranking system, which we consult to gain insights on which company or ETF will outperform or underperform the market. The ranking system is based on valuation, financial condition and return on capital and has predictive power. We observed that stocks with higher ranks had a strong tendency to outperform those with lower ranks over a period of one week. The data show that moving up 10 rank points translates to an extra annualized return of 1.7% in the past 10 years, if ranks range from 0 to 100. As a matter of fact, the S&P 500 (SPY) Index returned an annualized 2.5% in the same period. Details can be found in our methodology article: “ETF Ranking: A New Fundamental Approach That Drives Short-Term Return."

A company with high leverage ratio, as well as high total debt-to-equity ratio, will have a dire financial condition and will have a low rank from our ranking system. And a stock with a rank below 50 is expected to underperform the market. Among the listed REITs, only NLY fetched a rank above 50. Actually it is the group’s low ranks that urged us to take a close look at the risks embedded in REITs.

Nonetheless, REITs are still attractive due to their appealing yield and the stable outlook for interest rates. It's just that investors need to understand what may go wrong with REITs and have an emergency plan at hand.



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: One More Thing Investors Need To Know About REITs