Seeking Alpha

The Untold Truth About Mortgage REIT Investments

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Includes: NLY, O, SKT, VNQ
by: Jussi Askola
Summary

It is well-known that REITs are our favorite asset class for high-yielding total return investments.

Nonetheless, i's not all sunshine and rainbows. In this article, we highlight the dark side of Mortgage REITs.

We recommend investors to avoid Mortgage REITs and invest in undervalued Equity REITs instead.

With a strict selection of the best REITs, most of these downfalls can be avoided and investment performance can be materially improved.

Publicly traded REITs have historically generated higher returns with lesser risk than most stocks, while providing valuable diversification benefits. In fact, REITs produced up to 4x higher total returns than the S&P 500 (SPY) from 1997 until 2016:

REITs outperform stocks

Source

Therefore, most investors understand that they should invest in REITs, whether it's for:

  • High current income
  • Long-term appreciation
  • Inflation protection
  • Diversification

The more difficult part is to determine how to invest in REITs and, most importantly, whether you should invest your hard-earned capital into Equity REITs or Mortgage REITs.

  • Equity REITs - Own and operate income-producing real estate investments. The market often refers to equity REITs simply as REITs, because the majority of REITs are equity REITs.
  • Mortgage REITs - Provide financing for real estate by purchasing or originating mortgages and mortgage-backed securities and earning income from the interest on these investments.

We think that this article can help you decide. For us, there's no doubt: Equity REITs are much better vehicles for long-term real estate investing.

The reason why we are so confident in our choice is because Equity REITs have not only massively outperformed Mortgage REITs in the past, but they have done so while taking significantly less risk.

avoid mortgage reits

Source

Over the past full cycle, Equity REITs were not far from earning double-digit returns, despite suffering the sharpest crash ever in 2008. In comparison, Mortgage REITs returned less than 1% per year. Fluctuation was significantly more pronounced, dividend cuts were more frequent, and they produced very disappointing total returns. Does this sound appealing to you?

This outcome may sound surprising at first, but it is very much expected and even normal. There are real economic reasons why Equity REITs outperform and why this outperformance is expected to continue.

Here is the “untold truth” about Mortgage REITs:

#1 - Greater Conflicts of Interests and Management Inefficiencies

REITs can be managed internally or externally, and this seemingly unimportant issue can lead to massive return disparities.

  • Internally managed REITs: Hire their management as employees of the REIT.
  • Externally managed REITs: Outsource the management to an external asset management company.

Most Equity REITs are today managed internally, and this is the preferred option. On the other hand, most Mortgage REITs are managed externally.

Exceptions exist, but more often than not, externally managed REITs suffer from greater conflicts of interest, have higher G&A cost, and shareholder returns have been significantly lower over time.

reit conflicts of interest

Source

The main issue with the external management structure is that it will often incentivize “growth at all costs” and result in “empire building” behavior. The management team will seek to maximize the “size” of the portfolio rather than its “performance” to increase their management fees (which are tied to the volume of assets under management).

This one difference in management structure is an important reason why Mortgage REITs underperform Equity REITs in the long run.

#2 - Shaky Business Model with High Leverage and Interest Rate Sensitivity

The business model of Mortgage REITs is closer to a “bank” than a property investment. Mortgage REITs earn their profit by sourcing capital at cost X, lending it at rate Y, and earning the spread in between.

They borrow short, lend long, and so they are very sensitive to the interest rate curve - something that is completely out of their control.

They are much more reliant on borrowing and more sensitive to interest rates than Equity REITs. It results in a shakier business model with greater risk, frequent dividend cuts, and inconsistent growth.

Consider the following example: Annaly Capital Management (NLY) is arguably the “blue chip” of residential mREITs. Yet, this is its dividend track record:

annaly capital management poor dividend track record

Source

What good is it to earn a high dividend yield if you cannot count on it?

In comparison, Equity REIT blue-chips such as Realty Income (O) have historically been more consistent and produced much better risk-adjusted returns:

realty income dividend track record

Source

The business model of an Equity REIT is superior to that of a Mortgage REITs. Again, exceptions exist, but it is generally true that Equity REITs:

  1. Produce safer and more consistent cash flow.
  2. Are less reliant on borrowing to earn a good return.
  3. Are more defensive against volatile interest rates.
  4. Pay steadier dividends.
  5. Grow more consistently.

We view Mortgage REITs as “banks on steroids”. Steroids may boost the level of your dividend in the near term, but they also have side effects!

Mortgage REITs are particularly popular among individual investors because they tend to pay higher dividend yields. However, investors should know that their total returns have been significantly lower over the long run, and given the shaky business model, everything points out to more underperformance over the coming decades.

#3 - No Participation in Property Appreciation

One of the main reasons why real estate is such a powerful investment is because it tends to appreciate in value over time.

A well-located property in a favorable market is worth more today than it was 20 years ago, and will very likely be worth much more another 20 years from now. It is the result of growing demand for a supply-constrained commodity. This is also where the quote “Buy land, they ain’t making any more of the stuff” comes from.

REIT property appreciation

Source

While Equity REITs greatly benefit from property appreciation, Mortgage REITs are left out of the party.

  • Equity REITs earn growing rents and appreciation. As such, they are able to achieve significant organic growth even without raising additional capital.
  • Mortgage REITs, on the other hand, are often limited to fixed interest and lack the potential upside in property appreciation.

Owning a leveraged property that is growing in value and paying consistent cash flow sure seems more appealing than borrowing short and lending long to try to earn a spread that is risky and volatile.

Conclusion: Stick to Undervalued Equity REITs

Now that the untold truth of Mortgage REITs has been told and everyone is aware of their flaws, it is important to recognize that not “all” REITs are bad.

In fact, Equity REITs have historically outperformed almost all other asset classes with spectacular returns over many market cycles. They provide consistent high income along with market-beating total returns in the long run:

Source

Even better, those investors who avoided the messy Mortgage REITs and invested in undervalued Equity REITs managed to earn even greater returns. The best active REIT investors have managed to reach up to +22% annual returns over the same time period:

Source

This is what we aim to achieve by specializing in REIT investing. We want to maximize our chances of generating high total returns with only limited risk, while earning high income from our real estate investment. We believe that the best way to achieve this is by investing in Equity REITs, not in Mortgage REITs.

Most investors would likely be better off to avoid the entire sector and focus on undervalued Equity REITs instead. We get the appeal of earning a high yield, but you really do not need Mortgage REITs to achieve that. By combining Equity REITs with MLPs, Infrastructure investments, and other real assets, we are able to earn a close to 8% dividend that is safely covered at 68% and growing.

A Note about REIT Investing: To succeed as a REIT investor and earn high consistent income, we recommend to:

  • Closely monitor your REITs, including quarterly NOI and FFO performance.
  • Diversify your REIT portfolio with at least ten companies (there are over 200 publicly traded REITs, so please be selective).
  • Identify REITs with strong long-term fundamentals but affected by temporary challenges causing their valuation to decline and yields to rise.
  • Be ready to take advantage of market volatility, and look for opportunistic buying points.

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Disclosure: I/we 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.