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As most investors know, equity REITs own properties in a variety of real estate subsectors and account for 90 percent of the market capitalization of the REIT industry. While the other 10 percent consist mostly of single family home mortgages and, to a lesser extent, commercial property mortgages.

One development in the higher yielding space has been the explosive demand (52 percent increase between 2010 and 2011) of mortgage REITs, namely the residential mortgage REITs that include companies such as American Capital Agency (AGNC), Hatteras Financial (HTS), and Annaly Capital (NLY).

Anyone looking at Seeking Alpha (or related investment sites) will notice that the mortgage REITs have outperformed most asset classes over the past year. And a large portion of that outperformance has been from high dividends. The Bloomberg mREIT index shows 27 percent total return from a year ago, with less than half of that coming from price appreciation.

The High-Flying Mortgage REIT Buoys

A buoy is a floating device that can have many purposes and in "sea mark" terms a buoy is used to mark a maritime channel so that boats and ships are able to navigate safely. Buoys float on the surface of water and the bumpy devices are usually bright-colored since they are used to mark channels in a harbor.

Similarly, mortgage REITs are often subjected to choppy portfolio performance and they are often subject to unpleasant swings (or cuts) in dividend yields, especially when interest rates rise. Like a gravity-free buoy, mortgage REITs pay exceptionally high dividends because of the tremendous leverage they maintain. What's more, they tend to finance long-term mortgage securities with short-term repo.

The danger in the water of course is that the Fed maintaining extraordinarily low rates for a long time will generate tremendous demand growth for such leveraged product, as assets continue to increase exponentially. Like a warm sunny day, everyone feels comfortable in the water and who wouldn't with mortgage REITs "always" churning out satisfying income.

Adding to the rising interest rates, another fear of the murky waters is that mortgage REITs provide little to no transparency. Because they invest in pools of mortgages, mortgage REIT investors are only able to see the net income margin and book value of the overall portfolio. Due to the exposure (and little transparency) to change in interest rates, the earnings of mortgage REITs can be as volatile as a buoy in the wake of a violent storm.

Contrary to the risky value proposition, the buoy-like mortgage REIT model has gained considerable popularity as the high floating (and high yielding) sector has spawned a handful of IPOs and secondary offerings this year. Some of the high-flying mortgage REITs include CreXus Investment Corp. (CXS), New York Mortgage Trust (NYMT), Northstar Realty Finance Corp. (NRF), MFA Financial Inc. (MFA), Capstead Mortgage Corp. (CMO), Dynex Capital Inc. (DX), PennyMac Mortgage Investment Trust (PMT), Arbor Realty Trust (ABR), Two Harbors Investment Corp. (TWO), and AG Mortgage Investment Trust (MITT).

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Anchor Down with Steady and Reliable Equity REITs

Unlike equity REITs, mortgage REITs don't enjoy the depreciation shield on taxable net income; in the trailing twelve month period, the average mortgage REIT paid out 124% of cash flow as dividends to shareholders (source: Chilton Capital Management). Due to interest rate changes (and considerable leverage), mortgage REIT earnings are more volatile and several mortgage REITs have already cut their dividend this year.

Because of the more conservative debt fundamentals, equity REITs are considered more of an anchor, than a buoy. Accordingly, the proposition for equity REITs is the durability component that makes for a more attractive income stream - and a safe haven platform rooted by sustainable and consistent dividend yield. Owning "brick and mortar" is a fundamental characteristic for an equity REIT and the "deed-based" income model poses much less risk to the higher-yielding (buoy) REITs that are simply "paper mortgages," subject to risks of foreclosure, bankruptcy, and potentially large legal expenses.

Historically, equity REITs have outperformed mortgage REITs, and since 1972, equity REITs have doubled the returns for the high-floating mortgage sector (source: Chilton Capital Management):

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According to NAREIT, there are 128 equity REITs with a total market capitalization of $517.297 billion. The year-to-date total return for the sector is 17.54 percent with an average dividend yield of 3.26 percent (as of August 31, 2012). There are 27 mortgage REITs with a total market capitalization of $62.127 billion and an average year-to-date total return of 24.92 percent (average dividend yield is 12.35 percent).

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Low risk is directly correlated to dividend safety and the some of the most reliable equity REITs have enjoyed an extraordinary track record of not only maintaining, but also growing dividends. The elite group of "anchor" REITs are part of a larger group of public companies that are often referred to as Dividend Champions and Dividend Contenders. [Seeking Alpha contributing writer David Fish produces this "US Dividend Champion" report on his DRiP Investing Resource Center site.]

There are three REIT "dividend champions" and they include Federal Realty (FRT), HCP, Inc. (HCP), and Universal Health Realty Trust (UHT). There are seven REIT "dividend contenders" and they include National Retail Properties (NNN), Tanger Factory Outlets (SKT), Essex Property Trust (ESS), Realty Income (O), Urstadt Biddle Properties (UBA), National Health Investors (NHI), and Omega Healthcare (OHI).

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The Rising Tides of Interest Rate Risk

Equity REITs and mortgage REITs are both subject to interest rate risk. The mortgage REITs are the riskiest since any rise in interest rates usually means that interest rate spreads fall (short-term rates tend to rise faster than long-term rates) and that book values fall (higher long-term rates cause the book value of the portfolio to be marked down).

During the last rising rate cycle (2003-2005), short-term rates rose fast enough and high enough that the yield curve eventually went negative and mortgage REIT profitability went in the tank. Yields on mortgage REITs went from 15 percent to 4 percent, due to dividend cuts, and total returns during the 2003 to 2005 period were approximately negative 30 percent.

The historically low rates of return are at record lows and this period we are in now can inevitably create economic imbalances, often smoothed out by periods of adjustment that can be both prolonged and difficult - especially for mortgage REITs. This imbalance can be best explained by Tom Lewis, CEO of Realty Income, in his company's 2011 Annual Report and Letter to the Shareholders:

We might think of the past 30 years as being akin to an easy downhill ski run with evenly packed powder and little to block one's progress. Eventually, however, we do get to the bottom of the hill, which is where we may be right now with interest rates and there seems to be no chairlift in sight. A compelling graphic illustration of where interest rates have been, since 1962, is shown in a chart that tracks the history of interest rates for 10-year US Treasury notes, a leading benchmark for what other lenders charge. (See chart below) This chart depicts the story of a steady, downward trajectory of interest rates from their peak of over 15% in 1982 to a low of 1.9% by the end of 2011.

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By utilizing higher leverage (borrowing money to magnify returns), the mortgage REITs benefit from a steepening of the yield curve, which can increase profit margins by widening the spread between the interest cost of borrowings and the interest income from the mortgages themselves. Interest rates are typically much more volatile than real estate prices, so mortgage REIT investors will experience a much bumpier ride than equity REIT investors.

Warren Buffett explains the excessive risk concept and his warning for high-yielding swimmers:

It's only when the tide goes out that you learn who's been swimming naked.

Today mortgage REIT investors are enjoying good times, and they don't feel as though they are taking on excessive risks. However, when interest rates begin to rise, it will become increasingly apparent that these deep sea divers will have a more difficult time staying afloat.

Alternatively, it is the great investors who are able to predict the turbulence by both generating steady returns and by controlling portfolio risk. And of course, recognize the risk (rising interest rates) is an absolute prerequisite for controlling the risk.

Maneuvering uncertain economic headwinds can be difficult and picking the right balance of equities (the anchor and the buoy) can make you simply sea sick. One way to help you steer away from potential danger of loss (when risks meet adversity) is to cast your sites the most intelligent REITs and by making sure that your compass (dealing with the future) is your guide.

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Source: SNL Financial, Chilton Capital Management, NAREIT

Source: Intelligent REIT Investing: Recognizing Risk In Good Times And Bad