Equity REITs Vs. Mortgage REITs From The Perspective Of A Preferred Investor Part III

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Includes: AMH, ARR, BEE, BRG, BXP, CHSP, CIM, COR, FCH, HPT, MAA, MITT, NLY, NYMT, OAKS, PSA, SNH, SOHO, SPG, VNO
by: Norman Roberts

Summary

Of necessity, a diverse preferred portfolio must include REITs because of their ubiquitous presence.

Equity REITs are usually the best choice for the conservative preferred investor.

Mortgage REITs usually offer the greater yields because they usually are saddled with the greater risk.

Because I briefly discussed REITs in Part I & Part II of my Economics of Preferreds series, and because they are necessarily an important part of most preferred portfolios, I designed this article to further study them.

They are necessarily an important part of most preferred portfolios because of all the sectors of the market, REITs offer virtually the largest - and risk-wise, the most diverse - group of preferreds to choose from. Consequently, these preferreds offer yields that can be attractive to just about any preferred investor, be he a staunch conservative or an avid risk-taker.

According to Investopedia:

Equity REITS are responsible for acquiring, managing, building, renovating and selling real estate. Equity real estate investment trusts' revenues are mainly generated from rental incomes from their real estate holdings. Equity REITs typically invest in office and industrial, retail, residential, and hotel and resort properties.

Contrary to equity REITs, mortgage REITS generally lend money to real estate buyers or acquiring existing mortgages or mortgage-backed securities (MBS). While equity REITs typically generate their incomes from renting out real estate, mortgage REITs mainly generate their revenues from the interest that earned on their mortgage loans.

Hybrid REITs invest in both properties and mortgages, best described as a combination of the two, owning both real property and the mortgages on those properties.

Equity REITs invest in a variety of real estate ventures; the majority are listed below:

Multi-Family Residential REITs: invest in residential real estate properties that offer more than a single apartment unit, either located in an individual building or a large apartment complexes. Bluerock Residential Growth REIT (NYSEMKT:BRG) and Mid-America Apartment Communities (NYSE:MAA) are representative of this group of REITs. Although there many available to invest in, few offer preferreds.

Single-Family Residential REITs: hold mortgages on single-family homes. American Homes 4 Rent (NYSE:AMH) offers several preferreds.

Office and Other Commercial Properties REITs: own, lease, or manage office units, retail buildings, warehouses, distribution centers, and data centers. Boston Properties (NYSE:BXP), CoreSite Realty (NYSE:COR) and Vornado Realty Trust (NYSE:VNO), and Simon Property Group (NYSE:SPG) are some that offer preferreds.

Healthcare REITs: include medical or medical-related buildings, hospitals and long-term care nursing facilities. These REITs rarely, if ever, operate these facilities. In most instances they lease them and earn their profits via the rents they collect. Senior Housing Properties Trust (NYSE:SNH) and Five Oaks Investment Corp. (NYSE:OAKS) are two that offer preferreds.

Lodging and Hospitality REITs: are my long-time favorites and the sector that rescued me from another painful exit from the market. These REITs own, operate, lease, and develop hotels. Many are branded under well-known names, such as Hilton, Marriott, and Sheraton. Several that offer preferreds are Felcor (NYSE:FCH), Strategic Hotels & Resorts (NYSE:BEE), Chesapeake, Lodging Trust (NYSE:CHSP), Sotherly Hotels (NASDAQ:SOHO), and Hospitality Properties Trust (NYSE:HPT).

Self-Storage REITs: are considered some of the safest investments. Public Storage (NYSE:PSA) is probably the biggest and best that offers preferreds.

From the perspective of this preferred investor, I've determined that equity or eREITs, for the most part, are safer investments than their mortgage or mREIT counterparts, especially in a rising interest rate environment. I believe this is so because of the following:

Equity REITs

  • Equity REITs derive their income primarily from leases and rents. Consequently, they are usually able to raise those rates as they deem necessary and usually over a relatively short period of time.
  • eREITs also are tax-advantage because they able to depreciate their holdings for significant savings.
  • They are considered more transparent because their operations are more easily understood and their investors are able to see, touch and visit their holdings if they feel the need to. Initially when I invested in hotel REITs, I recall flipping through pictures of their hotels, which certainly gave me a feeling of a greater sense of security in my investment. I doubt if I would have made those investments otherwise.

Mortgage REITs

  • Mortgage REITs typically earn their income from mortgages, and if not floating rate, earn fixed rates over a longer period of time. And as interest rates appreciate the yield spreads they earn contract because they primarily work with shorter-term borrowed funds, that fund their longer term debt investments.
  • To increase their yields they often resort to increasing their amount of leverage, which is what most concerns me and one the main reasons I consider mREITs riskier investments.
  • To further increase yield, management is often tempted to invest in riskier products that offer increased margins.
  • Because they often invest in mortgage pools they become increasingly less transparent as far as I am concerned, and consequently I find it more difficult assess the REITs credit risk.
  • mREITs can also be negatively affected when interest rates decrease as well as when they increase because borrowers, taking advantage of a lower rate environment, often replace their higher coupon mortgages with lower rate ones that have recently become available.
  • Many mREITs are externally managed, for which they pay a fee, which might be okay in general, but on occasion some external managers might not have the best interests of the REIT's investors in mind while they execute trades and perform other duties. I might be wrong, but it's just my nature to be suspicious, suspicion nurtured by lots of the hanky panky I've witnessed during my time in the market.

Mortgage REITs hold portfolios of single family home and commercial property mortgages, consisting of agency or government-backed residential mortgages; non-government-backed residential and commercial mortgages; and those that purchase discounted high-risk mortgages. Because I am less risk-adverse, I tend to gravitate toward the riskier mREITs that offer preferreds: Annaly Capital Management (NYSE:NLY), Chimera Investment Corp. (NYSE:CIM), New York Mortgage Trust (NASDAQ:NYMT), AG Mortgage Investment Trust (NYSE:MITT), Armour Residential REIT (NYSE:ARR), and a host of others.

I hope that many of my more knowledgeable followers will add to the conversation in the following comment section and fill in any of the blanks I might have left.

Disclosure: I am/we are long MITT-B, ARR-A, ARR-B, NYMTO.

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.

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