The popularity of levered mortgage REITs (real estate investment trusts) will not stand the test of time. Over the next few decades, levered mortgage REITs will be viewed as oddities peculiar to an era with artificially low short interest rates and simultaneously high mortgage rates. It is likely that they will join the list of once-popular investment strategies like chasing yield from subprime collateralized debt obligations or the practice of day trading dotcom stocks.
More stocks are converting to REIT structures, which will distract investor attention from riskier levered mortgage REITs. Levered mortgage REITs are also struggling to maintain their high dividend payouts as the spread of mortgage yields over short interest rates tightens.
How mREITs Work
These REITs take levered positions in mortgage notes. They buy mortgage loans, use those loans as collateral to buy more mortgages, and then repeat this buying and borrowing process multiple times. The net effect is that these trusts purchase multiple times their value in mortgage loans on margin.
Currently, these positions are attractive because mortgage yields are higher than short-term interest rates. By borrowing short and lending long, these REITs exploit the spread between low short-term interest rates and higher long-term mortgage rates. They further exploit this spread by buying multiple times the value of the fund, allowing them to reap multiple times the spread.
Mortgage REITs that previously delivered high dividend income are at a crossroads. The companies that initially had their borrowing costs held close to zero by the Federal Reserve have been suffering reduced incomes and dividends since the Fed's most recent quantitative easing announcement. This has prompted investors to seek alternative securities for investing their money. In a telephone interview, Co-Chief Executive Officer of Annaly Capital Management (NYSE:NLY), Wellington Denahan-Norris, acknowledged that her company was facing challenges, but she insisted that they were not unique, saying, "It's not just at the mortgage REITs where the returns in this market are being put under assault."
If borrowing rates continually increase, levered REITs may be forced to review their debt-heavy capital structures since the use of more debt may result to greater decline in dividends and net incomes. However, Two Harbors Investment (NYSE:TWO) co-chief investment officer Bill Roth endorses caution. He insists that mortgage REITs must be careful of historical trends. According to the Bloomberg article linked above, in a telephone interview, he stated, "We're not in a game where we're going to jack up leverage or change our risk profile to manufacture some return." However, many REITs might choose to be less conservative.
Essentially, the spread between mortgage rates and short-term borrowing costs could tighten, destroying the economic niche that these REITs are exploiting. Finally, there is an endless parade of political meddling in mortgage lending. Such game-changing moves can rock the mortgage market, threatening early prepayments for holders of mortgage loans.
There are also risks specific each individual levered mortgage REIT. The portfolio manager could make a string of bad bets on mortgage pools, which fail to provide expected income or plummet in resale value. The loss of income would result in a fall in dividend income to shareholders, and the price of the REIT would fall in the secondary market as fixed income investors become disenfranchised. Worse yet, write-downs to REIT portfolios might trigger loan covenants with their lenders. Losses may result in illiquidity or insolvency, and ultimately default. Clearly, borrowing short and lending long is not a risk-free strategy, as hundreds of bank failures since 2008 attest.
Here Come The REITs
There are many new entrants who will compete for investors in the REIT space. More REITs are hitting the market as CFOs realize that they can pass through taxes by re-positioning their firms as REITs, which trade at much higher valuations. Who wouldn't want to instantly have their stock trade at higher values and pay less taxes?
The conversion of stocks to REITs is being met with investor enthusiasm. The shares of data center operator Equinix (NASDAQ:EQIX) rose 7.5 percent to an 11-year high when the company communicated that its plan to convert it to a real estate investment trust had been approved.
Conversion to a REIT is expected by 2015, according to the company, if shareholders approve the change in status, and if the U.S. Internal Revenue Service gives it approval for the conversion. The change to REIT status can provide tax benefits for the company. With this change in status, a merger between Equinix and Digital Realty is in the offing.
Equinix is not a traditional REIT business. It provides the required infrastructure that enables mobile devices to connect to the Internet, cloud computing, and other technology trends. Equinix works with major companies such as Amazon (NASDAQ:AMZN), for which it provided cloud services through Amazon Web Services; as well as Rackspace Hosting (NYSE:RAX), which works with servers. Equinix is responsible for providing access to high-speed Internet, as well as power and cooling to the lines supplying it.
Unsustainable Dividend Payouts
Fixed-income investors have been attracted to these levered mortgage REITs because of their high dividend payouts:
American Capital Agency
Annaly Capital Management
These high dividend yields are hard for fixed income investors to resist, especially in today's low interest rate environment. However, each of the firms on this list has an unsustainable dividend payout. They also dabble in extensive leverage, as is captured in high debt-to-equity ratios.
There are also special investor-level tax implications to the dividend paid by REITs. Their distributions are not taxed as long-term dividend income. Instead, they are taxed as regular interest. As such, these investments are prime candidates for tax-advantaged accounts like IRAs or charitable foundations, but are not appropriate outside of a tax-advantaged account.
Levered Mortgage REIT Risks
There are many macroeconomic threats facing this REIT subsector. The values of their mortgage holdings are not guaranteed, and could possibly drop below the value of the outstanding short-term debt a levered mortgage REIT owes. On the other hand, short-term interest rates could rise from the near-historical lows where they lie today.
A more distant threat could also surface. The popularity of corporations repositioning themselves as REITs could eventually cause politicians to change the tax laws that allow REITs pass-through income. As REITs, they must then distribute at least 90% of income from their holdings.
In general, investors should avoid initiating new positions in levered mortgage REITs in this environment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.