mREITs As A Proxy For Residential Real Estate

Includes: AGNC, NLY
by: James Shell

About six months ago, I wrote this article. In it, I evaluated three investment alternatives for a cash investment: Leave it in a CD, buy a residential single family home, or put it in a mortgage Real Estate Investment Trust. As we sometimes do, it's time to review the findings of the original article to see if any of the underlying conclusions have changed, and if so, what to do about it.

Certificate of Deposit

At the time of the original article, the best available local rate on a federally insured Certificate of Deposit in my area was 2.02%, and to tell the truth, I never imagined they could get much worse, but at the same bank, the current rate on a 24-month CD is 0.95%, and the highest rate in the area is now 1.1%

Thankfully, as it turns out, if I'd bought the CD in December, I would still be locked in at the earlier rate, but if I had to make the same investment today, it would look like this:

Initial End Year 1 End Year 2 End Year 3
$ 100,000 $ 101,100 $ 102,212 $ 103,336
Interest Rate 1.10% 1.10% 1.10%
Ending Value $ 103,336
Rate of Return 1.10%
Total Ending Cash $ 103,336
Investment Return (3 yr) $ 3,336

At first glance, this is not a very attractive investment. Note that in addition to deferred consumption, there is no guarantee that in 2 years, when this thing comes due, you'll be able to get the same rate.

Residential Real Estate

I drove through that same neighborhood the other day, and the property that I looked at in the previous article apparently sold and is no longer pink. However at the current moment, there are seven very similar places on exactly the same street for sale at an average of $92K, which is actually lower than the $93K for the house that we noted earlier.

This pleasant one is fairly typical, it is 3 bedroom, 2 bath, 1600 square feet, and is listed for $94K.

A different pink house is on the market: a bank foreclosure on the same street for $72K. The place has "repair issues", which in this area, typically means that someone carted off the air conditioning units to sell for the value of the copper.

According to the current Case-Shiller Index of Property Values report, home prices in my area are still declining at a rate of 0.91% per month, which still equates to a roughly 10% decline this year.

I did check this morning's "for rent" listings, and my usual sources say that there are 83 single family homes for rent in this area right now, a couple in this subdivision are listed at $1150 per month. Also, some of the very pleasant local 2 bedroom apartments in the area are now renting for about $900 per month, (no yard work) so there is some competition in the market on the low end as well.

If I had done what I was tempted to do, which is buy the pink place last December, I'd have had to work feverishly over the holidays to get the place in shape, spend the $7K to do the repairs, and I am still reasonably sure I could have rented it for 5 months at $1000. I'd still be negative in cash flow by $95K, and I would be dreading every ring of my telephone for fear that it would be my tenants telling me that they are moving out, because school just ended.

Rental Property
Selling Price $ 93,000
Improvements/Trans Costs $ 7,000
Total Investment $ 100,000
Appreciation -10.3%
Market Value
Rent/Mo $ 1,000
Rental Months (so far) 5
Rent Income (so far) $ 5,000
Rent Growth Rate 0
Net Rental Income $ 5,000
Current Resale ?
Net negative cash flow ($95,000)

A couple of minor points: Obviously there would have been a problem with liquidity: With my original selling price plus upgrades and repairs, I would be hard pressed to sell the place right now at any price, much less the $100K I would have into it. There is no real evidence that the decline in prices in general has stopped in this area, and obviously, there is some peril that other homes in the neighborhood could deteriorate like the second pink one above.

Note: At a price of $72K, the second pink house is tempting as well. I would need some more information on the exact repairs needed to make the place rent-able, but if I could accomplish it for $10-15K, the numbers would start to look better. At the low entry price, some additional cash investment and $1000 per month rent, rented 11 months out of the year, the calculation would look like this:


Year 1

Year 2 Year 3
Selling Price $ 73,000
Improvements/Trans Costs $ 12,500
Total Investment $ 85,500
Appreciation -10.3%
Market Value $ 76,694 $ 68,794 $ 61,708
Rent/Mo $ 1,000
Rental Months/Year 11
Annual Rent Income $ 11,000 $ 11,000 $ 11,000 $ 11,000
Rent Growth Rate 0
Total Expenses $ 4,550 $ 4,550 $ 4,550 $ 4,550
Net Rental Income $ 6,450 $ 6,450 $ 6,450 $ 6,450
3 year Rental Income $ 19,350
Avg ROR 7.5%
Ending Investment Value $ 81,058
Investment Return (3 yr) $ (4,442)
Investment Return (NYSE:AVG) -1.7%

At the lower entry price, this might be pretty close to a break-even investment, particularly with any improvements I make on the place potentially adding to resale value at the end of the investment.

All of this would involve work, though, and there is some merit in letting someone else do this who is good at it.

The Mortgage REIT

I did a series of articles not too long ago, the last of which is here. I looked at American Capital Agency (NASDAQ:AGNC) and Annaly Capital management (NYSE:NLY), the two largest agency-backed mortgage REITs.

If I had invested the same $100,000 in each of the two on December 30, not collecting the December dividend, but collecting the March dividend, the state of my investment right now would be as follows:

Price 30-Dec Shares Current Dividends Cashout Value ROR
AGNC 28.08 3561 32.22 4452 $ 119,195 19%
NLY 15.96 6266 16.7 3446 $ 108,083 8%

I was not especially charitable to NLY at the time of the articles, but you can see that in both of these cases, the proverbial investor would have been much better off on the mortgage end of the transaction compared to the home-owning end.

I would also add that with about five mouse clicks, I could liquidate either investment, and walk away with a pretty nice 5-month return, although I might rather wait around for another few days for the June dividend to be paid.

So, what to make of all of this:

First of all, I would still repeat my original statement that it is better to be on the mortgage end of the transaction than in the real estate itself.

Secondly, although the rents do seem to be fairly stable at the moment, it is clear that the home prices have not bottomed out in this area, and will not do so as long as it is better to be a lender than a borrower, or, until the entry price versus rent relationship changes. This is the very definition of deflation, and you can see why it is so dangerous.

Thirdly, the world is full of perils, and there are still no guarantees on anything, especially consistently good performance by the REITs, which are vulnerable to interest rate changes and changes in other government policies. The next six months may not be as good as the last.

Fourthly, traditionally, bank CDs have paid in the neighborhood of 5%. The current state of CD rates represents a transfer of wealth away from people who have deferred consumption and accepted liquidity risk (the savers). This is all in an effort to subsidize borrowers and keep the financial sector healthy. This situation is not sustainable either.

Do with this information what you will, we will check into this again in a few more months.

Disclosure: I am long (AGNC), (NYSE:ARR), (NYSE:TWO), (NYSE:IVR), (NYSE:CYS).