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A Safer Alternative to mREITs

Mortgage real estate investment trusts (mREITs) are singing an alluring siren song to income investors right now. After all, the top ones are yielding around 11%.

The problem is, most are playing a dangerous game of Russian roulette that could result in a capital wipeout if rates rise… and the industry is no stranger to failed companies. Just look at Thornburg Mortgage, which filed for bankruptcy in April 2009.

Luckily, if you understand the risks involved, you can get the high yield without endangering your invested capital.

Risky Leverages Yield Double Digits

Mortgage REITs invest in home or commercial mortgages or mortgage bonds. The most common type of mREIT invests in agency mortgage-backed securities guaranteed by Fannie or Freddie Mac.

Since the mortgage bonds are effectively guaranteed by the U.S. government, there’s no credit risk. And because they invest in real estate-related assets, they don’t suffer income tax on their earnings if they pass 90% of those earnings on to investors in the form of dividends. This setup ensures a decent dividend yield nearly all of the time.

But there’s a downside, too: Mortgage REITs that are invested without leverage are safe but boring. Since 30-year home mortgages yield 4.1% today, it would probably be difficult for a REIT to attract cash at that level.

Thus, in order to juice up their yields, mortgage REITs often leverage their portfolios using short-term repurchase agreements that cost 0.1% or so. The gross spread between asset yield and liability cost ends up being close to 4%. Of course, they have to hope the repo market stays open, but so far that hasn’t been a problem.

Once they leverage that a few times, their returns get pretty juicy.

For example, take the two biggest home mortgage REITs, Annaly Capital Management, Inc. (NLY) and American Capital Agency Corp. (AGNC). The latest balance sheets show NLY with a debt-to-capital ratio of 5.3 times and AGNC at 5.9 times. In current market conditions, they’re both nicely profitable. Plus both REITs, trading around net asset value, have a dividend yield in the 11% range.

So what can go wrong? Lots.

The Fear of Rising Rates

Mortgage REITs leveraged to this extent are essentially picking up quarters in front of a steamroller, as NLY and AGNC discovered last year. In fact, if rates rise, mortgage REITs find not just one, but two steamrollers rumbling forward to squash them.

If short-term rates rise, the juicy gap between portfolio yields and funding costs disappears – or even reverses. (Historically, we’ve had several periods when short-term rates were higher than long-term rates.) In that case, the mortgage REITs run out of income and have to cut or even eliminate their dividends.

If long-term rates rise, mortgage bonds decline in value, and REITs have to sell them at actual market prices, not the price at which they bought them. And with debt of more than five times equity, that could potentially wipe out a trust’s capital, forcing it to close. Of course, it can manage the risk using interest rate derivatives, but no REIT can eliminate it completely without killing profits.

Just last year, the home mortgage REITs got in trouble when rates started to go up. The 10-year T-bond rate rose from below 2% to around 3%, though it has since come down to 2.35% today. And in 2012, both NLY and AGNC had debt of close to 10 times equity, which forced them to scale down very quickly by selling bonds and repaying funding in order to avoid being wiped out. That has since affected their share prices and dividends. In fact, AGNC’s shares have fallen 31% in the last two years (and its net asset value nearly as much), while its quarterly dividend has been cut from $1.25 to $0.65.

A Safer Alternative

Luckily, if you don’t like the Russian roulette game played by home mortgage REITs, there’s an alternative: commercial mortgage REITs.

Now, the U.S. government doesn’t guarantee commercial mortgages, so there’s credit risk. But most commercial mortgages do carry floating interest rates, so there’s little interest rate risk. Plus, you don’t need to worry very much about a spike in interest rates. Instead, you just need to worry about a recession during which the stores, offices, and warehouses that issued the commercial mortgages might stop paying their debts.

One such firm is Resource Capital Corporation (RSO), a smaller REIT with a market capitalization of $700 million. RSO invests primarily in commercial mortgages and has a dividend yield of 14.6%, based on its $0.20 quarterly dividend.

Like the home mortgage REITs, it’s levered, with debt at 1.6 times capital. The difference is that its assets and liabilities are close to matched (fixed rate loans are only 14% of the portfolio), so you’re taking a levered credit risk and not much levered interest rate risk.

That’s fine, since we’re confident that management will successfully navigate potential problems in the credit markets. After all, they’ve been busy buying their own stock this year, having purchased a net 325,840 shares in 2014, a good sign for the future.

Finally, there are a couple of wrinkles: For starters, the dividend isn’t currently covered by earnings, but is expected to become so within a year. However, the shares are selling at only 75% of their net asset value, so there’s a certain margin for error.

Either way, RSO is worth considering if you’re interested in diversifying your portfolio and getting great yields with less risk than you find in mREITs.

Good Investing,

Martin Hutchinson