Are mortgage REITs finished? Not so fast

A pullback in this sector has created an opportunity to add double-digit yields to your portfolio.

By StreetAuthority Jul 19, 2013 11:38AM
Miniature home on sheet of percent signs © Comstock/Getty ImagesBy David Goodboy

Appearances can be deceiving. While on the surface everything these days seems to be moving along without a hitch, there is a huge underlying force steering the U.S. economy.

I am not talking about a dark and evil conspiracy plotting to overthrow the government. The force I am talking about is much more mundane -- yet it is more powerful than any political movement. In fact, it takes billions of dollars each day to put the reins on the world's most powerful economic control mechanism.

This vast force is better known as interest rates.

Sorry to disappoint anyone hoping for a revelation here, but the power of interest rates is beyond any need to exaggerate. Stock prices, economic growth and even the rise and fall of empires can be tied to the interest rate equation.

Stock investors feel the effects of interest rates every day in their portfolios. The old rhyme "When rates are low, stocks will grow; when rates are high, stocks will die" couldn't be more accurate. The extreme bull market we have witnessed over the past several years is tied directly to ultra-low interest rates. However, there is a big change brewing just under the economy's surface.

Interest rates are starting to creep higher, and the stock rally is slowing. The first stock investors to directly feel the negative effects of rising interest rates are those who hold instruments directly tied to rates, such as mortgage real estate investment trusts, known as mortgage REITs or mREITs.

These formerly top-performing dividend machines have been smacked lower since rates started inching up in May. Favorites such as Annaly (NLY) and American Capital (AGNC) are trading lower by 25% and 20%, respectively. On average, mortgage REITs are down by more than 18% on the year.

The reason for this is that REITs need to borrow money to increase their assets. Therefore, any small decline in asset values can have a multiplicative effect on their equity. When interest rates are stable, mortgage REITs outperform Treasurys. The opposite also holds true: Mortgage REITs underperform in an environment of rising interest rates. This is known as convexity, and simply put, convexity risk is what has knocked the mortgage REITs down.

Fortunately, not all mortgage REIT stocks have been punished to the extent that American Capital Group and Annaly have. The primary reason is that both those mortgage REITs are built on fixed interest rates. Simply, fixed-rate mortgage REITs are more affected by climbing interest rates than their adjustable-rate and hybrid peers.

This has to do with the way adjustable-rate mortgage and hybrid REITs are leveraged. For example, hybrid REITs are leveraged, on average, just three to six times; compare this with fixed REITs, which are leveraged at six to nine times.

Let's take a closer look at an adjustable-rate mortgage REIT and a hybrid mortgage REIT.Source: WolframAlpha

Capstead Mortgage (CMO)
This adjustable-rate mortgage REIT is trading higher by nearly 10% this year. It pays an annual dividend of $1.68, which equals a 10.8% yield.

MFA Financial (MFA)
This is a hybrid mortgage REIT consisting of both adjustable and regular mortgages. It is trading higher by nearly 10% on the year but is off by 3% over the past few weeks. Yielding nearly 17% with an annual dividend of $1.58, this hybrid REIT is a top performer.

Risks to consider: During the past week, all mortgage REITs have bounced higher on stabilizing interest rate speculation. Although adjustable-rate and hybrid mortgage REITs have a much higher tolerance for rising rates than fixed-rate mortgage REITs, most mortgage REITs are negatively affected by rising rates. With the rates so low, it is only a matter of time until they start rising again. Use caution in this sector because the high yields mean equally high risk.

Action to take:
The mortgage REIT sector is extremely attractive because of the higher-than-normal yields thrown off by these stocks. If you believe higher interest rates are inevitable, avoiding the standard fixed-rate agency mortgage REITs makes sense for everyone but short-term traders. However, longer-term investors can gain protection from rising interest rates but still retain exposure to the high-yielding sector by investing in hybrid or adjustable-rate mortgage REITs. I still see opportunity for longer-term investors in adjustable-rate and hybrid REITs despite the inevitability of interest rate increases.
 
David Goodboy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.


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6Comments
Jul 19, 2013 2:22PM
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Personnally, I rather enjoy the 18% yield on AGNC, thus I have to disagree with your thesis that only traders benefit from holding fixed Mortgage REI, especially at these   current valuations.  If you hold long, the panic selling eventually fades, rates stabablize,   and you bank all of the reinvested dividends. If you are looking for capital gain, yes, FI M-REITs are a trader's nightmare right now, but a good option for an income investor if you are willing to benefit from risks and wait out the panic selling.  Long AGNC.
Jul 20, 2013 7:06PM
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Who the hell worries about a thumbs up or down on their post...Who cares.

 

Although having a diversified portfolio is always the best choice...

Having maybe a few different REITS are not a bad choice, to upside overall yield on ports.

 

Maybe just recently with fall from grace, because of Bernanke's(FED) remarks and positions;

But long term REITS, have prepaid some of those losses in VG dividends. And they are still coming.

But do bear closer watching at this date, with the possibility of slightly paring some positions..

Considering the near future and the economy moving forward. 

Jul 19, 2013 1:48PM
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You all realize that people with heavy exposure in REITs are thumbing down our posts but have no posts of their own because they cannot dispute the truth. The word "trust" is inaccurate... "con" would be a better word but who would invest in an acronym like REIC. That would wreak havoc in the Kool Aid world.  
Jul 19, 2013 12:21PM
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The article writer is goofy. REITs (Real Estate Investment Trusts) benefit bookkeeping, not economy. As huge properties fail (mall anchors and stand-alone big boxes) communities already reeling from touch revenue scenarios will buckle. You can only cook so many books and fudge so many ledgers. The secondary problem is the sheer volume of idiots who suddenly think they are real estate moguls and their lousy properties. Small business can't afford to be duped, there are no more cash cows for bail anything. I see plenty of apartment complexes falling behind on their rolling maintenance and no one relishes paying rent for a lack of services. REITs are about to pay-back, don't expect them to be cooperative or above-board.
Jul 19, 2013 12:36PM
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Gee, let me see if I get this. The "author" is touting these REITs as a investment opportunity. The very securities that took down the economy in 2008. Just one of those times I'm glad I'm not rich, so I don't have to worry about getting suckered in by such wonderful advice.
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