MREITS - High Yield Or High Risk? What You Always Wanted To Know But Were Afraid To Ask!

MREITS (Mortgage Real Estate Investment Trusts, like regular REITS are entities involved with Real Estate that by their very nature pay no corporate taxes and generally pass along higher dividends than the average dividend yielding corporation, however those dividends are then "non-qualified" dividends and the shareholder pays tax at his/her regular tax rate. For that reason, they are excellent for IRAs, 401Ks, and other tax advantaged venues.

As the name implies, unlike regular REITs, MREITs do not own real estate per se, rather they own a portfolio of mortgages and/or mortgage backed securities (MBS). While there is a wide range of MREITs, designed to meet various ranges of risk tolerance, there are three distinct business models that represent fundamentally different types of MREITs. First there are the Agency MREITs, exemplified by Annaly Capital Management, perhaps the most revered and one of the very largest. These Agency MREITs hold mortgages that were issued or backed by quasi governmental agencies such as Fannie Mae and Freddie Mac. The default risk on this type of mortgage is considered practically non-existent. As a result of lower risk the yield is lower than is found on MREITS investing in riskier Non-Agency backed mortgages. This second group, the Non-Agency MREITs, such as Chimera Investment Corp., have portfolios consisting totally of mortgages and MBS that are not Agency backed or issued. Finally there are the hybrid MREITs, such as Invesco Mortgage Capital, which, as you might guess, are made up of a combination of Agency and Non-Agency mortgage assets.

Frequently Agency MREITs increase their return by utilizing high leverage, so where they have a lower risk of default, they may make up for it with a higher risk by operating on a higher ratio of borrowed money than a Non-Agency MREIT. A hybrid MREIT may have higher default risk than a pure Agency MREIT, but higher leverage than a pure Non-Agency MREIT. Clearly there are a lot of variables, and all MREITs are certainly not alike. It is important to understand exactly what type of MREIT you are investing in, what type of securities it holds, and how much leverage it employs, in addition to evaluating management's track record.

Basically Mortgage REITs make money on the difference between the short term interest rates that they pay to borrow money, and the long term interest rates on the mortgages that they hold in their portfolio. Their potential for profit is the difference between the short term interest rates they pay to borrow money to obtain the mortgages, and the long term interest rates of the mortgages or MBS themselves. This brings us to the single most critical factor in MREIT performance other than the ability of the management team...that is the interest rate environment.

Recently with the FED holding short term rates at historic lows, the environment has been ideal for all kinds of MREITs, but what will happen when short term interest rates begin to rise? This in itself is not as easy a question as it may seem, because again, not all MREITs hold the same type of mortgages. Some are long term fixed, and some are adjustable rate mortgages (ARMs). Obviously, there will be a significant difference in the impact of rising interest rates if the mortgages in a portfolio are fixed or are ARMs. Further, while most MREITs hedge against interest rate increases to a certain extent, some hedge significantly more than others. So, since hedging costs money like insurance, the more hedged an MREIT is the more protected against interest rate changes, but the less potential for profit.

Each MREIT has its own specific profile vis-a-vis Agency-backed or Non-Agency backed, leverage, fixed rate or ARMs, hedged or not. Finally, there are those MREITs that focus specifically on Commercial Real Estate and Commercial Mortgage Backed Securities (MBS), those that focus on Residential Mortgage Backed Securities (RMBS) and those that do a combination of CMBS and RMBS. In short, there is no easy way to evaluate the MREIT segment. It requires looking at each MREIT individually and determining whether its specific characteristics meet your investment goals and tolerance for risk. It is probably for this reason and degree of difficulty, that many folks (including brokers and investment advisers) steer clear of MREITS, and it is for the same reason that they offer a significant opportunity to those willing to put in the time to determine which ones are right for them and their investment criteria.

So, what will happen when the FED begins to increase interest rates again? When it becomes apparent that interest rate increases are imminent, there will be a rush to the MREIT exits as the herd mentality will paint all MREITs with one brush, and determine that any rise in interest rates will be bad for all MREITs. The fact is that interest rate increases are much worse for some than others, depending on their amount of leverage, hedging, and mortgage terms (fixed vs. ARMs). Some will be able to ride a tide of rising interest rates with little or no impact to their dividends and book value, while others will be hit severely. So not only timing is important in buying and selling MREITs, but the differentiation in investment style is equally important. Again, this complexity makes MREITs somewhat more difficult to evaluate and therefore less in demand which results in even higher dividend rates, since yield goes up as price per share goes down, and price and demand, as we all know, are directly related.

Based on recent statements from the FED, and barring totally unforeseen circumstances, it would appear that the FED will not be raising interest rates during the next twelve months, and the environment that has been so favorable for MREITs will continue to nurture them. For those who have the time, ability and desire to do the required due diligence, these investment vehicles offer an unusual opportunity, at the present, to generate yields that are unachievable in other areas of the high yield universe such as MLPs, BDCs, Telecoms, and utilities. In this case, however, nowhere has the saying caveat emptor (buyer beware), been more appropriate.

Copyright 2011 Boyd Investment Holdings LLC. All rights reserved worldwide.

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