Ride REITs to Profit in 2011

It’s no surprise that the real estate industry has been Wall Street’s whipping boy for quite a while now. Home values, previously Main Street’s most tangible measure of wealth, got shellacked over the course of 2007 and 2008, and millions of Americans found themselves in dire straits as a result of overleveraging their home values in pursuit of consumption. Today, housing remains a “scary” investment… That’s why we like it.

Of course, that Main Street anxiety hasn’t been relegated to home prices…

Real estate-related investments have similarly been held underwater in the last few years as investors on and off Wall Street have avoided premature exposure to this sector. Among the hardest hit have been real estate investment trusts, or REITs. With exposure to things like commercial real estate project, mortgages and exotic debt instruments, who could blame investors for shying away from these stocks? They’re scary — maybe scarier than housing.

But most investors don’t realize that REITs don’t really provide exposure to the real estate market — and they’re not designed to.

Instead, REITs are designed to be income-generation vehicles that remove nearly all of the risks of their underlying assets. Landlord REITs almost universally rent out their properties with long-term triple-net leases that lock in rental rates (with regular increases) and take away tax and maintenance liabilities. Landlord REITs have exposure to real estate in only the most long-term, roundabout sense. Their distant cousins, Mortgage REITs, work in much the same way, owning incredibly safe mortgage investments that essentially strip away exposure to real estate and borrowers.

So what kind of “safe” investments do mortgage REITs own? Typical portfolios are made up of a variety of mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs) — the same scary three-letter securities that are blamed for the mortgage meltdown in 2007 and 2008. But before you close your browser window, let me explain exactly why that’s a good thing for your portfolio in 2011…

For starters, while they share the same name, the types of MBSs that most mortgage REITs invest in aren’t nearly the same kind of investments that took down the real estate market in years past. Instead, financially stable firms invest almost entirely in agency securities, which are backed by the full force of the U.S. government. Put simply, mortgage defaults don’t matter for these investments.

What does matter is how long most mortgages last.

You see, mortgage REITs make their money by taking advantage of the difference between short- and long-term interest rates. Because there’s more risk (and more opportunity cost) in lending money to someone for a longer period of time, long-term interest rates are normally much higher than short-term rates. By taking on short-term borrowings to fund their long-term mortgage investments, these firms take advantage of a leveraged spread with essentially no credit risk.

So while the term “mortgage REIT” sounds like it has a lot to do with the housing market, these investments are actually a way to play interest rates. And because REITs are required to pay out the vast majority of their incomes to shareholders as dividends, the income generation at these firms is substantial.

Implications of Higher Interest Rates

Until recently, there’s been very little volatility in the interest rate world. With the U.S. economy knee-deep in a recession, the Fed’s top priority has been to keep rates as close to zero as possible in order to stimulate borrowing. But now, as the recovery begins to get a bit more mature, increasing murmurs on Wall Street are pointing to the possibility of rate hikes in the near-to-intermediate term.

That uncertainty has already been priced into most interest rate-sensitive stocks.

Even so, it’s not interest rate hikes that are a concern for mortgage REITs — instead, it’s the rate of change between long- and short-term rates that is crucial. If short-term rates climb faster than long-term rates, the liquidity spread shrinks and mortgage REIT profit margins get squeezed.

There are a handful of attractive small-cap REITs on the market right now – and most share these core characteristics. If you’re looking for a dependable income stream, make sure that the firm you’re looking at primarily invests in agency-backed securities. If that’s the case, it’ll behave like the rest…

Sincerely,
Jonas Elmerraji
Penny Sleuth

April 28, 2011

Ride REITs to Profit in 2011 was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

This story was originally featured on Penny Sleuth.

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