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Warren Buffett is recorded as saying "be greedy when others are fearful." One of the best examples of this is in the mREIT sector. After the subprime mortgage crisis, investors wouldn't touch investments related to the housing industry. This is the fear.

The greed would have been purchasing 1,000 shares of a decent mREIT when they started in the height of the financial crisis. 1,000 Shares of American Capital Agency (NASDAQ:AGNC) would have cost $20 each, for a total value of $20,000. Over the next 5 years, the yield starts at about 25% and works its way down to 15%. The share price went from $20 to $35. Either the share price or the dividends would have been an extremely lucrative return on investment, to be sure. However, combine the two with a Dividend Reinvestment plan. The oversized yield feeds back into purchasing the stock, which goes ahead and continues giving oversized yields. The return just from the dividends is about 100% total over 5 years. The return from capital appreciation is 75%. Total, that is 175%? Dividend Reinvestment is over 300% (calculations made with this). Some pretty nice returns.

This is because investors saw mREITs as a very risky investment. But is there a way to reduce the clear risk in these assets, while still collecting an above average net yield?

The Present

One of the biggest risks in mREITs is that the spread in interest rates that they use to generate income will get compressed, and their hyper-leveraged investments begin to lose profit in a hurry (an increase of 1% spread times 5 is a 5% profit, where as a decrease in the spread by 1% times 5 reduces profit by 5% - explanation here). So once the dividend income drops, the price will drop also, because there really is no competitive moat. It is pretty much an early warning indicator, but a theory of competitive markets says that even before the dividend drops, it will have been factored into the price already. This means that you won't be going in for the quick dividends and getting out at the first sign of trouble.

Also, there is the risk that we are too far along in the economic recovery, and that the artificially large spread in the interest rates will not be sticking around. It doesn't look like the market will be allowing you to take advantage of this power stock anytime soon. So lets dream up a strategy that will fit.

Options are an interesting beast. Used by small direct-email promoters, they are apparently "the best way to triple your money." You know, its kind of like the immortality potion, unlimited energy for the world, and curing world hunger.

The Future

But options aren't only good for sensationalistic titles, they are good as an insurance policy. Using options, we limit the potential downside in the case of the interest rate spread compressing, and the stock price dropping to make it nearly impossible to get out of the investment without a net loss. Such is the difficulty of market timing. Here is the strategy.

Taking a look at the option books on Yahoo Finance, the January 13th Puts cost $.50. This is a 3 month Put to cover for a decline in price between now and the next quarterly dividend payment. AGNC has been paying out a $1.40 quarterly dividend for almost 2 years, only having recently reduced it to $1.25. The idea is to purchase a new option every 3 months when the protection runs out. The dividend payment will cover the insurance policy easily.

This leaves the profit per quarter at $.55 or $.70. Annually it is estimated at $2.20-$2.80, and at current prices of $35, it is still a 6%-8% yield. Generally, when using this strategy to protect your capital investment, the option eats so far into the returns of a normal dividend stock, that it isn't feasible to do this on other stocks if you needed to keep the dividend income.

Conclusion

We bought the option to keep the principal safe. We used a portion of the dividend to purchase the option, and we still keep a generous portions of the returns. Think about it. Decide for yourself. The investing wisdom of Warren Buffett must mean something, seeing as he has been, well, successful. The fear that permeated these types of investments is wearing down. This is shown by the increasing share price and decreasing dividend yield. However, there is still enough fear left to make a substantial amount on the investment.

Be greedy, my friends.

Source: Take Advantage Of Above-Average Returns From mREITs With Minimal Risk