The Risks Of Residential/Mortgage REITs Are Too Many

by: Valuentum

Investors seemingly can't get enough of residential/mortgage REITs. But should investors be concerned about reaching for yield in this group?

The residential REIT industry consists of REITs that own and manage housing, multi-family and apartment communities as well as mortgage REITs that invest in agency securities in which the principal and interest payments may be guaranteed by the government. The industry has been materially impacted by recent changes in the lending landscape, defaults, credit losses, and significant liquidity concerns during the recent global financial crisis.

The firms in this industry generally are not subject to federal taxes on their taxable income to the extent that they annually distribute all of their taxable income to stockholders. As a result of this business structure, many firms have elevated distribution yields, but almost all of them generate a return on tangible equity that is less than our estimate of their respective cost of capital (generally 10%). Further, almost all constituents in the group have distribution payout ratios higher than 1, revealing a significant dependence on the healthy functioning of the capital markets for new funding, which cannot be guaranteed and at times can become prohibitively expensive.

Further, the reliance on debt to finance properties exposes residential REITs to the risk that their future cash from operations may at some point in the future be insufficient to make required payments of principal and interest. Leverage, the amount of debt exposed to variable interest rates and future free cash flow generation need to be monitored very closely (as REIT distribution requirements limit available cash on the balance sheet). The success of a mortgage REIT depends heavily on its ability to acquire assets (agency securities) at favorable spreads over borrowing costs, which can rise materially in the event that short-term interest rates increase or the market value of its investments decline (margin calls are also possible).

Our research indicates that the highest-yielding firms in the group have a tendency of having the greatest amount of leverage (as measured by total assets divided by total shareholders' equity), the most aggressive business models, and offer the greatest level of risk to investors. Generally speaking, we're uncomfortable with 'asset/equity' leverage levels above 6 for any constituent in the group, given the long-term threats of a rising interest rate environment, which could significantly impair operations should income be exceeded by the expense incurred to finance investments. Companies with this leverage profile include American Capital (NASDAQ:AGNC), Annaly Capital (NYSE:NLY), Apartment Investment (NYSE:AIV), ARMOUR Residential (NYSE:ARR), CYS Investments (NYSE:CYS), New York Mortgage (NASDAQ:NYMT), and Two Harbors (NYSE:TWO). All things considered, the large distribution yields presented by some constituents in the group may not compensate investors for the tremendous risks inherent to their respective business models.

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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.