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We've been doing a little work lately trying to analyze the prospects for a few residential mortgage-backed securities, which are attractive on the basis of their current high dividend yields. Today's project is to look at a few investment alternatives:

Certificates of Deposit:

This bank is paying the highest interest rate in the area. I could go down this afternoon and buy a $100,000 CD and get the maximum rate of 2.02%. Over the next three years, my investment will look like this:

This is a nice, relatively safe, low-risk investment that is not paying very well at all in historical terms, as we have discussed in previous articles. Of course, I will make sure that the bank is FDIC insured because since 2008, 69 banks have failed in this area mostly because of the aftermath of the real estate collapse and foreclosure situation.

Residential Rental Property

Under the theory that one should buy into an asset when the prices are depressed, I could go out this afternoon and buy this single family residence in the suburbs. I am quite familiar with the neighborhood. The schools are good, crime is low, and there is good freeway access.

In this zip code, real estate prices declined by 10.3% last year, but rents remained stable. A similar 4-bedroom house just up the street has been advertised for the last 6 weeks to rent at $1,100 per month, so perhaps I would be able to keep this place rented for 11 months per year at $1,000 per month.

I could pay the $93K asking price in cash for the house, and since it is nearly 20 years old, I would probably have no problem spending an additional $7K in miscellaneous transaction costs, repairs and upgrades.

Here is a summary of the investment, making the assumption that past performance is an indicator of future results, and the value of the place continues to decline:

Here is a breakdown of the income stream, given the generous assumption above that the rents will remain constant, and allowing for real estate taxes, the homeowners association dues, and a repair allowance:

I would have a positive cash flow for three years, and a nominal 6.5% return on cash, but the hit would come in the last year when I tried to sell the property. My overall 3 year return would be negative, I'd have been better off to stick with the CD.

Note: The fact that the rate of return on this investment is worse than the CD is exactly why real estate values in this area are continuing to fall. The selling price of this house is lower than it was when it was built in 1992, but if you value the place as a function of its rental income, which is how it should be valued, the selling price needs to be reduced to $50,000 to get a rate of return equal to the C, given the decline in selling prices.

The property is still priced in the marketplace with the underlying optimistic assumption that the selling price will either remain the same or go up during the three year investment period, notwithstanding the actual data from the market that says otherwise. This market is nowhere near the bottom, although perhaps the stable rents are a good sign.

The Residential Mortgage Backed Securities Funds

We have been working with a little group of RMBS funds, whose business is to finance residential mortgages. Perhaps one of them was initially involved in the financing of the above property.

Here is a price chart for this group:

It's been a tough year for these funds, as it has for the overall market, the average decline in this group is 14.3%, although without the two outliers it improves to a decline of 6%.

Also, out of the 7 funds listed above, 5 have cut their dividend in the last four quarters, the dividend yield calculated on the entry price dropped an average of 9% during the year. The market values have declined faster than the dividends, however, all of these funds actually have higher yield than they did a year ago.

So, given the same pessimistic assumption above, that past performance is an indicator of future results, here is the outcome of the hypothetical RMBS investment:

The nominal $46,000 positive cash flow in this case more than makes up for the price depreciation, the rate of return is positive, more so if you reinvest the dividends at the indicated rates. Note: If you do away with the pessimistic exit price assumptions, the average rate of return becomes 6.5% for the residential real estate case, and 15.4% on the RMBS case.

So, what are we to make of all of this?

First of all, it is clear that being a holder of the underlying asset, namely the house, was a worse investment than holding the mortgage, or sitting on near-cash in the form of the CD. That is the defining characteristic of a deflationary market, in which cash is king, and in which there is a transfer of wealth from the borrower to the lender.

Second, even using the conservative, pessimistic assumption that the nominal fund price will go down by 14% per year you're still better off with the RMBS than you are with your money in the CD. It is true that there are no guarantees on anything, and the decline could be even worse.

Third, at least in this area it is clear that there are still some serious underlying problems with the economy, and that might be enough to make the proverbial cautious investor to stick with the FDIC-insured CD.

Fourth, logcially, if the underlying market for the RMBS, namely the residential real estate market, remains so sick, the proverbial cautious investor may be concerned that some of the problems will move upstream. The high yields of the moment are due to the exceptionally low borrowing costs for these funds, which is the result of a deliberate government policy. The risk that this situation will change is the risk that an owner of these funds is accepting in exchange for a potentially much higher return.

My universe of RMBS funds was as follows:

Chimera Investment Group CIM
Invesco Mortgage Capital IVR
Two Harbors Investment TWO
CYS Investments CYS
American Capital Agency AGNC
Armour Residential Reit ARR
Annaly NLY

The world is chaotic, and there are no guarantees on anything.

Source: RMBSs As A Proxy For Real Estate

Additional disclosure: I also own and live in a residential property in the adjacent ZIP code to the one in the article.