Within a sub-sector of all REITs lies a seemingly attractive group of equities that offer high dividend yields around 10%, but the real story about the safety of those dividends is much different. They are highly leveraged and any change in interest rates can be catastrophic to your investment. Tim Plaehn recommends you avoid this type of REIT.
Finance REITs, those that own or originate real estate loans, typically offer very high dividend yields which make them attractive to income-focused investors. These REITs fall into two very different camps concerning their business models and how they generate free cash flow to pay those big dividends. One type of mortgage REIT is dangerous to your wealth, even though it may sport a 10% or higher dividend rate. The other type can generate high and growing dividends for a long time.
The Agency MBS Game
The majority of finance REITs follow the same business idea of owning a leveraged portfolio of residential mortgaged-backed securities (MBS). The federal agency backed MBS have AAA credit ratings, which allow a REIT to finance the purchase of large amounts of MBS with borrowed money. The business model works like this:
A REIT has $10 million of equity capital. It uses that capital to buy $80 million of agency MBS, borrowing $70 million against the mortgage securities. This would be seven times leverage. The MBS pay an average interest rate of 3%, and the REIT can borrow short term at 1.5%. The leveraged portfolio will produce a net yield of 13.5% on equity (3% on the equity and 1.5% times 7 on the leveraged holdings).
Out of the interest earnings, the company pays expenses and buys interest rate hedges to protect against changing interest rates. Unfortunately, hedging is an imperfect art and tends to not work when it is most needed. This recent news item about the earnings from mortgage REIT CYS Investments (NYSE:CYS) tells the tale in just a few words:
“CYS Investments last night reported a big drop in book value as the effect of sharply higher rates more than offset the company's hedges. Core income failed to cover the dividend as prepayments also rose.”