REM invests in mortgage REITs to earn an income stream of about 10% annual yield. That income is distributed to shareholders in quarterly payments. The benefit of exposure to REM’s portfolio outweighs the risks of management error and exposure to mortgage REITs as long as the Fed keeps interest rates low in the U.S. Economy and the REITs maintain market value.
About mortgage REITs
All REITs avoid paying corporate income tax by investing in the real estate market and distributing at least 90% of the income to shareholders. Mortgage REITs invest in residential or commercial mortgages and mortgage-backed securities (MBSs). The residential mortgages may be agency-guaranteed or unguaranteed. Agency-guaranteed mortgages protect the principal, but the principal of unguaranteed mortgages carries the risk of default. Owners of MBSs risk loss if the security is overvalued and the underlying mortgages default1.
Profit scheme. Suppose a building loan pays 4% on the principal (i.e., 4% yield). The REIT may buy the mortgage with its own cash to earn the 4% yield or leverage the purchase with borrowed cash to seek a higher yield. The following table illustrates the financing of a mortgage (or MBS) for increased returns2:
LEGEND: Unleveraged return = (mortgage yield * own cash). Leveraged return = (mortgage yield – short term yield) * borrowed cash. Return on equity = 100 * (unleveraged return + leveraged return) / own cash
Risk. Interest rate spread is the difference between short-term interest rate paid by the firm (i.e., REIT) to buy the mortgage and the long-term interest rate collected from the mortgage by the firm. Fed policy is the biggest driver of short-term interest rate3. The book value of MREITs is the balance of mortgages and MBSs owned by the firm less all liabilities. An increase in long term interest rate will lower the book value, increase leverage, and limit the ability to raise capital through secondary offerings4.
Risk management: The 3 sell signals for mortgage REITs are 1) a quarterly interest rate spread less than 1.75%, 2) an increase in short term interest rates – especially above 4% –, and 3) a 15% decline in mortgage REIT stock prices below the 52 week high. Consider using Annaly Capital Management (NLY) as a primary marker for the mortgage REIT industry 5.
Comments about REM.
The underlying Index measures the mortgage real estate (MREITs), mortgage finance, and savings association sectors of the U.S. equities mkt. About 69% of the recent index mkt cap is concentrated in REITs.
The underlying assets.have the following risks:
- MREITS risk default on payments, lower interest rates, and costs of leverage.
- REITs risk landlord ownership of real estate.
- Mortgage finance companies risk default on payments.
- Savings associations risk losses from lending.
Investment strategy. At least 90% assets are securities in the underlying index. Less than 10% assets are not indexed securities that include futures, swaps, and cash equivalents. The fund may lend assets up to 30% total asset value.
Copyright © 2012 Douglas R. Knight
1. U.S. Plans Charges on Bond Fraud. FEBRUARY 1, 2012, By SUSAN PULLIAM, JEAN EAGLESHAM and MICHAEL SICONOLFI. http://online.wsj.com/article/SB10001424052970204740904577195472977887722.html?KEYWORDS=charges+on+bond+fraud
2. How to Win Bernanke’s War on Savers with a 19% Yield January 18, 2012 by Martin Hutchinson, Global Investing Strategist, Money Morning Martin Hutchinson
4. Mortgage REITs And Double-Digit Yields: What’s The Catch? January 15, 2012 by John D. Thomason. http://seekingalpha.com/article/319696-mortgage-reits-and-double-digit-yields-what-s-the-catch
5. Common Sense Formula For Taking Profits On Your Mortgage REIT Investments, Tom Dyson and Nirav Desai. Copyright 2011 by COMMON SENSE PUBLISHING, http://www.palmbeachletter.com/issues/201102CSI-AppendixA.asp