What the REIT market is telling us

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"More money has been lost reaching for yield than at the point of a gun."
Raymond DeVoe Jr., Market Strategist

Few quotes are more insightful, yet few quotes are more ignored. I continually see investors lose money reaching for yield. 

Some investors have been attracted to mortgage REITs thanks to their juicy yields. But the yield comes tethered to unacceptable risk. Mortgage REITs borrow short-term funds at a floating rate. They then use their funds to buy long-term fixed-rate mortgage-backed securities. 

To goose cash flow, mortgage REITs employ debt - and a lot of it. Debt-to-equity ratios of 500%, 600%, or even 1,000% are common in the industry. Leverage is a wonderful tool when market winds are at your back. But when winds turn to frontal gales, cash flow and asset value quickly dissipates. 

Today, the winds are shifting to front facing for the mortgage REIT industry. This is bad news for many income investors who own mortgage REITs.

That's because mortgage REITS make big profits when interest rates fall. Today, interest rates are rising, and they're suffering as a result. At the same time, the values of their mortgage-backed securities are falling. And that increases the risk of margin calls.

Consider Annaly Capital ( NLY ) , a popular mortgage REIT.

A couple years ago, Annaly investors were receiving per-share quarterly dividends between $0.60 and $0.70. Based on an average share price of $17.50, a $0.65 quarterly produced a 15% yield on investment. 

I'm sure Annaly's juicy payout and lush yield attracted many unsophisticated investors, who where drawn in like moths to a flame. Many of these investors have since been burned.

Annaly's quarterly dividend has been continually reduced over the past two years. Indeed, the dividend has been reduced in seven of the past eight quarters. That 15% yield has been reduced to 9% on a $17.50 cost basis. Meanwhile the stock has plunged 35%.

I'm hardly surprised investors are suffering loses. Annaly reported a 0.98% net interest spread in the second quarter. In the same year-ago quarter, the net interest spread was 1.54%. I expect the spread to continue to narrow as interest rates continue to rise. 

To be blunt, I dislike the mortgage-REIT model. I don't even view mortgage REITs as REITS. They're really financial firms that leverage their portfolio of securities to unconscionable proportion. 

A REIT, properly speaking, should be viewed as a real estate investment. That's just one of many reasons that I like to own REITs that actually own property. All the REITs in the High Yield Wealth portfolio are landlords that own actual property and focus on commercial real estate. 

Gladstone Commercial Corporation ( GOOD ) is just one of these REITs that I do recommend. The company owns 73 cash generating commercial properties.

What's more, Gladstone doesn't whipsaw investors: Dividends are paid monthly, and have been continually maintained at $0.125 per month for the past six years. Investors are assured of a consistent 8% yield on their investment. It's not 15% one year, and 5% the next.

If you want a higher-yield real estate investment, buy a commercial REIT. Don't reach for yield in a highly leveraged mortgage REIT masquerading as a real estate investment. Their risks simply aren't commensurate with their reward.  



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: GOOD , NLY

Wyatt Investment Research

Wyatt Investment Research

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