Equity REIT Or Mortgage REIT? Resist Dividend Temptation

Sep. 27, 2021 3:16 PM ETAGNC, ARR, ARR.PC, AVB, CPT, ESS, NLY, TWO, TWO.PC, INVH24 Comments

Summary

  • In a world where interest rates are historically low, mREIT yields remain quite high.
  • I can understand the temptation to collect those big dividend checks, but remember that total return is what really matters.
  • Equity REITs have consistently outperformed mREITs in total return and based on fundamentals I don't see that changing.
  • This idea was discussed in more depth with members of my private investing community, Portfolio Income Solutions. Learn More »
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Real estate investment trusts (REITs) are among the top performing sectors this year and for good reason. REIT fundamentals are strong and their valuations are reasonable. The same cannot be said for much of the market. Given this relative strength in both fundamentals and market performance, more investors are coming into the REIT area.

Money is flowing into both equity REITs (eREITS) and mortgage REITs (mREITs) and I suspect many are moving to mREITs for their huge dividends. Equity REIT yields are around 3% right now and mREITs yields are as high as 6%-11% depending on which ones you choose. I get the temptation to go with mREITs, but I firmly believe equity REITs will continue to have better total returns.

Let me begin with discussing the structural differences and go on to show how that impacts long term performance.

Equity REITs and mortgage REITs: differences in business model lead to differences in risk profile

Equity REITs own the properties and through that ownership either collect rent checks from the tenants to whom they rent or directly collect the revenues that the property produces (hotels, timberland and operating real estate).

Mortgage REITs are at a more senior tranche, owning the mortgages attached to the real estate. Their revenues consist of interest payments on those mortgages and are protected by the collateral of the property itself since loan to value ratios are usually significantly less than 1 to 1.

Generally speaking, the higher one invests in the capital stack the lower the risk, so how is it that when equity REITs have an average dividend yield of just under 3%, mortgage REITs still offer yields around 10%? Shouldn’t the more senior tranche of investment have the lower yield?

Well, the difference comes down the interaction between spreads, leverage and return on equity.

Owning a mortgage loan fundamentally and objectively is lower risk than owning the equity tranche of a property. However, because of this low risk, the return on invested capital (ROIC) is much lower. For an equity REIT, ROIC is more or less synonymous with acquisition cap rates which depending on property sector is often between 4% and 10%.

ROIC on mortgages is much lower, perhaps in the vicinity of 2% to 5%. One can get higher if they go way out on the risk spectrum to junky properties/counterparties, but for institutional caliber properties the return on invested capital is quite low on a mortgage.

Nobody is going to invest in a mortgage REIT that has an expected return on equity of 2% to 5% so the mREITs have to pump up the return on equity (ROE) by levering up. Agency mortgage REITs have among the lowest risk investments in that their securities are backed by the government so aside from scenarios where the U.S. government defaults, they are nearly guaranteed return of principal. As a result, the spreads here are the narrowest which forces the agency mREITs to have to lever quite substantially to get to a decent ROE.

Thus, in order to get to a return on equity around 10%, the various types of REITs generally have to lever as follows.

  • Equity REITs with high cap rates only need slight leverage
  • Equity REITs with medium cap rates: 1:1 leverage
  • Commercial mREIT: 2:1-5:1 leverage
  • Agency mREIT: 7:1-10:1 leverage

The leverage levels in real life vary significantly between companies, but that is the qualitative concept.

As a result, it is unclear which type of REIT is riskier. Agency mREITs have by far the safest assets, but suffer the risk of being levered to the gills. In theory, leveraging such a safe asset should not incur much risk, but in practice, when markets get shaken up the leverage forces selling out of the safe assets at adverse pricing which can even force them to sell below the level of the government guarantee.

In contrast, equity REITs have riskier assets, but because leverage is so much lower market volatility has much less impact.

The total level of risk is in the same ballpark, but the origin of risk is quite different.

  • mREITs are risk sensitive to market volatility
  • eREITs are risk sensitive to economic fundamentals of their properties

Which risk profile is better?

I heavily favor the risk profile of eREITs. Equity REITs are tied to the actual economy whereas mREITs are tied to the market’s perception of the economy. I’ll trust the actual fundamental economy over the market any day of the week and the Covid crash gave a perfect example as to why real-world fundamentals are more reliable.

For clarity, I am referring to actual risk to the companies rather than price volatility of the company stocks. In any given market dip, the stocks of both eREITs and mREITs are highly susceptible to fluctuation just like any other stock. The actual level of damage to long term company value works quite differently.

Covid was of course a tragic event from a humanitarian standpoint, but from an economic standpoint it was more of a head fake. It created some true economic damage, but the perceived level of damage feared by the market and even the smartest economists was on a whole different tier.

As such, market prices sold off massively more than was fundamentally justified in hindsight and the reason this is relevant to this discussion is that the selloff actually fundamentally harmed the mREITs while it did not have much effect on the fundamentals of the eREITs.

See, the mortgages that the agency mREITs own are held on the balance sheet in a mark to market fashion, so even though the government guaranteed 100% of par value, if that mortgage is trading at 50% of par value that is its mark to market in that snapshot in time. As these intrinsically very safe securities got marked to market at absurdly low levels, it created massive margin calls given the high leverage of the agency mREITs. They were forced to sell the mortgages at a fraction of what they were worth in order to cover the margin calls.

It was a seemingly impossible scenario in which these securities which were guaranteed a certain recovery by the government somehow recovered far less than the guarantee.

The most amazing thing about all of this is that almost none of the mortgages actually defaulted. The mortgages remained fundamentally rock solid through the entirety of the crisis and it was simply the leverage creating risk where there otherwise wasn’t much risk.

In contrast, equity REITs were largely unharmed by the market’s panic and instead followed the trajectory of real fundamentals. Sure, the eREIT stocks sold off, but a selloff without fundamental damage is not a problem for investors that have the courage to hold. Most eREITs continued to have positive cashflows throughout the crisis and most eREITs are now at FFO/share higher than they were before the crash. That is a full recovery.

There are sectors that have not fully recovered and those are the areas where there was substantial real economic damage:

  • Malls
  • Hotels
  • Movie theaters

The take-home point of this section is that eREITs are responsive to the real economy whereas mREITs are fundamentally exposed to market panic.

The difference shows up in long term returns

eREIT outperformance

eREITs as a whole have substantially outperformed mREITs over long stretches of time, but I try to minimize comparing apples and oranges, so let us look specifically at the housing related eREITs and mREITs.

The agency mREITs, single family rental equity REITs and the apartment equity REITs all deal in the same underlying area which is the fundamental need for housing. The different business models of equity REITs versus mREITs show up in the return numbers.

Over the last 10 years, the big equity REITs, Invitation homes (INVH), Essex (ESS), Camden (CPT), and Avalon Bay (AVB) have substantially outperformed the big mREITs, Agency (AGNC), Annaly (NLY), Armour Residential (ARR) and Two Harbors (TWO).

Graphical user interface, chart Description automatically generatedSource: SNL Financial

The disparity in total return is not just market pricing, rather it is fundamental in nature. Each of these equity REITs has grown earnings significantly.

Chart, table, bar chart Description automatically generated

Source: SNL Financial

The U.S. economy consistently grows over time. There are hiccups and recessions but the long term trend is up and to the right. Equity REITs own the property that drives the U.S. economy and will follow its trajectory. As GDP grows so do rental revenues. That has been the trend for decades and I do not anticipate an inflection point at which that stops.

mREITs are just a spread game. When the loans are paid off there is no lasting property ownership. The mREIT is forced to reinvest the proceeds at whatever the market spread happens to be at the time. The companies are at the mercy of the market spreads, prepayment of loans, interest rate fluctuations, curve flattening or steepening and whatever else goes on.

The four agency mortgage REITs discussed here are, in my opinion, the best of the bunch. Each of them is run by highly capable management teams with brilliant strategies and responsible hedging. The challenge is that mREITs are stuck working with market spreads and therefore have razor thin Net Interest Margins (NIM). They, in theory, could run an unlevered portfolio of agency RMBS and quite safely return a couple percentage points per year, but that level of return is untenable to the market so invariably they lever up and come up with a reasonable strategy to get a double digit annual return.

In the good times when markets are running smoothly they achieve this and legitimately cover their amazing dividends. However, it is not possible to hedge against everything and even the intelligent minds working at these companies cannot see the future to know what the next hiccup is going to be. Miniature disruptions are ubiquitous throughout every industry, but the mREITs have to deal with these disruptions at 8:1 leverage and consistently over time that does some damage. Each of the four mREITs has had consistent book value erosion.

Graphical user interface, application, table, Excel, bar chart Description automatically generatedSource: SNL Financial

I get the temptation to invest in mREITs. 9%-11% dividend yields are juicy, especially in comparison to the 1.7% to 2.88% yields of the comparable eREITs.

A picture containing table Description automatically generatedSource: E-Trade streamer intraday 9/21/21

It's just a tough business. Maintaining that yield requires taking risks that even the best in the business cannot always navigate successfully. As a result, shareholders aren’t really getting the stated yield. Sure the dividend checks come in, but at the same time market price is eroding along with book value.

Graphical user interface, chart, line chart Description automatically generatedSource: SNL Financial

After accounting for loss of principle, the total return for mREITs has been quite unimpressive.

I would never exclude a security just because of poor historic price performance. Often that can just mean that a stock is opportunistically cheap. In this case, however, the problems seem to be structural in nature. Quite simply, it is challenging to make tiny spreads generate big returns. That has been true for the past decade and I don’t think anything has changed.

I would much rather invest in equity REITs where the U.S. economy functions as a tailwind. As GDP rises, rents tend to rise with it. So rather than a structural headwind that the mREITs are facing, equity REITs have a dependable tailwind.

I know it always feels like the economy is on the precipice of disaster, but the numbers don’t lie. This is about as up and to the right as an 80-year chart can get.

Chart, line chart Description automatically generatedSource: FRED

The above chart is real GDP, so this is after taking inflation into effect. U.S. GDP rises over time and REIT earnings are closely tied to GDP.

Equity REIT dividend yields are not particularly impressive at the moment, but they come with growth and what I believe will be a strong composite total return (dividends and capital appreciation).

A couple exceptions where mREITs might be opportunistic

Preferred securities among the agency mREITs are quite stable. The book value erosion that has been happening to the common does not impact the preferreds unless it were to get to an extreme level, so when the agency mREIT preferreds trade below par they can be a great opportunity to get both capital appreciation back up to par and a nice coupon.

Among the non-agency mREITs there are some unique models. Some of them are using originations, servicing, and other niche capabilities to generate income in excess of market spreads. When well executed, these strategies can be quite profitable.

Thus, I am not implying that all mREITs are bad, rather that the space in general is challenging so one must choose more carefully. The equity REIT pond is much easier to fish in and in my opinion likely to continue to outperform.

Dividends are scarce, we provide the solution

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  • Access to a curated Real Money REIT Portfolio
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You will benefit from our team’s decades of collective experience in REIT investing. On Portfolio Income Solutions, we don’t only share our ideas, we also discuss best trading practices and help you become a better investor.

This article was written by

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