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Avoid Leverage When Looking for REITs

As the price of oil fell, master limited partnerships (MLPs) were devastated.

Income investors seeking to goose their monthly income had few alternatives to turn to, which led many to choose real estate investment trusts (REITs).

In general, REITs are a sensible choice. But within them lurks a hidden danger: leverage.

But as long as excessive leverage is avoided, REITs can make a sound long-term income investment.

Here’s how to do it profitably – and safely.

The Dangers of Leverage

There are two types of REITs:

  1. Mortgage REITs, which invest in the mortgage debt of either residential real estate (generally guaranteed by Fannie Mae or Freddie Mac) or commercial real estate.
  2. And equity REITs, which invest in real estate stocks themselves.

Leverage is especially dangerous in mortgage REITs.

Whether in mortgage REITs subject to interest rate risk, or in equity REITs subject to illiquidity risk, leverage could increase the chance of a bankruptcy in a downturn.

Take mortgage REIT American Capital Agency Corp. (AGNC), for example. Its debt is around six times its equity. The company finances its home mortgage assets in the repurchase agreement market, thereby picking up six times the spread between short-term and long-term interest rates.

It also has a peculiar income statement, with no operating income and substantial “other income” from its activity in the derivatives market.

This gives it a net income figure that fluctuates wildly, even when interest rates are relatively stable. That’s why the company shows a net loss of $779 million in the first quarter of 2016, a relatively quiet time in the debt markets.

Add it all up, and even a dividend yield of 12.7% isn’t enough to compensate us for the risks.

Those risks involve capital losses, due to American Capital’s assets declining in value as interest rates rise, and a loss in income as short-term rates rise and remove the profitable “spread” between its short-term funding and its long-term assets.

Another mortgage REIT, Resource Capital Corp. (RSO), avoids many of American Capital’s leverage problems, although it still isn’t a solid investment.

Resource Capital invests in commercial mortgage loans, primarily with floating interest rates, so it doesn’t have as much interest rate risk as American Capital.

Its leverage is also lower, with debt only 2.3 times equity – a reasonable level since its assets are mortgage loans. And it offers an even more spectacular yield – 13.3% based on annual dividends of $1.68, and is trading at only 49% of net asset value, so there’s a little cushion to take care of hiccups.

The problem is, if you look back, Resource Capital lost more than half its value in the 2008-09 downturn, and dropped again last year when some loans went wrong.

There’s not much point in having a solid dividend yield if you have to give it up in capital. So although Resource Capital seems attractive, buyer beware!

Choosing a Safer Option

You’ll also want to avoid high leverage on equity REITs, as well as areas where there are signs of overbuilding (which is due to eight years of ultra-low interest rates).

Take the hotel industry, for example. It’s enjoyed an excessively good run, with massive overbuilding of increasingly larger projects. The retail sector, however, is in the early stages of a massive shakeout, as more shoppers are spending their money online and major retail chains are struggling to survive.

I’m also wary of the office segment. Companies are discovering that they can save money on office space by having employees who work mostly on the road or at home share desks.

In the equity REIT sector, you might want to consider EPR Properties (EPR), which specializes in entertainment, education, and recreation properties in the United States and Canada.

EPR has a monthly dividend of $0.32 – a yield of 5.4%. Those dividends are somewhat in excess of earnings, but are solidly covered by operating cash flow, which doesn’t fluctuate very much. The company is a substantial, diversified REIT with market capitalization of $4.5 billion. And its balance sheet is in decent shape, with a debt-to-equity ratio of less than 1 to 1.

There’s no reason why EPR’s businesses should get in trouble anytime soon, unlike retail properties and office space.

Of course, a recession would cause difficulties. But EPR’s stock price is currently four times its level in 2007, before the financial crisis hit. That, above all, is an assurance that the company isn’t diluting its equity to pay dividends, as so many REITs do.

The REIT sector is filled with snares for the unwary, especially after so many years of ultra-low interest rates.

But by avoiding leverage and the sectors most vulnerable to it, income investors can secure themselves a decent income and capital value that will at least spring back after any recession.

Good investing,

Martin Hutchinson