“Regular” REITs typically buy physical properties, find someone to manage them, and rent them out. They collect rent checks and avoid paying taxes on most of those profits if they pay out most of their income as dividends (under the terms of their tax loophole, which frees them from tax on their income. they distribute 90% of their profits in the form of payments). This is the reason why REIT stocks generally offer high returns.
Mortgage REITs (mREITs), on the other hand, do not own buildings. They have paper. Specifically, they buy mortgages and collect interest. How do they make money? By borrowing short term (assuming short term rates are lower) and lending long term (if long term rates are, as they tend to be, higher).
This business model prints money when long-term rates are stable or, better yet, falling. When long-term rates fall, those existing mortgages become more valuable (because new loans pay less).
Of course, the traditional mREIT gravy train goes off the rails when rates rise and the value of those mortgage portfolios falls. Historically, rising rate environments have been very bad for mREITs and have resulted in lethal dividend cuts.
But smart mREITs like New Residential Investment (NRZ) are poised to profit as rates soar. NRZ has broadened its portfolio of investments and services in recent years to be able to benefit from the higher tariffs. It is now the largest non-bank mortgage service rights (MSR) owner in the world.
MSRs are not the loans themselves; it’s the fees to repay those loans – a subtle but important difference.
MSRs typically earn 0.25% of the payments they collect. My wife and I recently refinanced our house and our mortgage service company, Truist Bank, is easily making money for the right to pay off our mortgage. We already have our automatic payment account!
The potential risk for MSRs is that interest rates fall. If so, homeowners like us will consider refinancing again and the mortgage (and service charges) will be “called back” sooner.
This is far from the case, however, with interest rates already close to their historic lows. Sure, they could fall through the basement, but we bet they won’t.
Just look at how NRZ has navigated the 2021 rate hike environment:
NRZ Book Value Up 17% & More This Year
This is what we want to see in a potential investment in the mREIT as Treasury rates rise and the Federal Reserve faces increasing pressure to raise its own benchmark rate.
Read on and we’ll explore three of the best mREITs on the market – which earn 8.9% on average – to see if they’re similarly designed to handle higher long-term rates.
AGNC Investment Company (AGNC)
Dividend yield: 9.0%
We’ll start with AGNC Investment Corp. (AGNC), which invests almost entirely in Mortgage Backed Securities (MBS). At the end of the third quarter, AGNC’s $ 84.1 billion portfolio included $ 53.7 billion of residential MBS, with most of the remainder ($ 28.3 billion) in the “to be determined” position.
TBAs are literally “to be announced” securities that will involve buying or selling an agency MBS at a price, face value, issuer, etc. predetermined at a later date, but the MBS will not be identified until shortly before the settlement date. TL; DR: We know it’s MBS, but that’s it.
What we do know, however, is that the lion’s share of AGNC’s portfolio is fixed rate; nearly 90% of the agency’s portfolio is made up of 30-year fixed-rate mortgages.
Source: Shareholder presentation Q3 2021
This is a warning sign, as is AGNC’s performance against a background of rising rates so far in 2021:
AGNC Book Value Declines
What’s even more troubling than the potential for lower prices is the possibility that a period of continued weakness could lead to lower dividends – again. AGNC manages its dividend through the skin of its teeth, which has forced mREIT to cut four times in the past six years, and several times before.
Imagine a healthy dividend graph. It is its opposite.
What good is a 9% dividend today if there is little reason to believe it will be 9% next year?
Starwood Real Estate Trust (STWD)
Dividend yield: 7.4%
With Starwood Property Trust (STWD), we sacrifice some return to get “only” 7% annual income and more … but in turn, we could have peace of mind.
Starwood is also involved in mortgage-backed securities, but the majority of its business is in commercial lending. It has around 10% exposure to residential loans and infrastructure loans, with the remainder tied to real estate investments and real estate investment and service firms.
Source: Starwood Investor Presentation from November 2021
Of course, the type of loan Starwood gives is not very important as the interest rates will impact it. And good news on that front: In its core business of commercial lending, 96% of loans are floating rate, giving STWD a better chance of weathering the blows.
Starwood BV at least walks the water in this increasing rate environment
What if you are wondering if you can count on that return of over 7%? Be aware that the dividend has not been reduced since 2009 – even in a tumultuous 2020 that saw many of its peers hack into their payments.
Annaly Capital Management (NLY)
Dividend yield: 10.3%
Now let’s take a look at Annaly Capital Management (NLY), the largest mortgage REIT in the United States, with a market cap of around $ 12 billion and assets of $ 94 billion.
Its yield of over 10% is also one of the highest in the industry.
NLY also invests in agency MBS secured by residential mortgages guaranteed by Freddie Mac, Fannie Mae or Ginnie Mae. It will also invest in commercial MBS and even mortgage management rights just like New Residential.
Unfortunately, MSR doesn’t just save money
Annaly technically invests in MSRs, but she does not invest much. The estimated fair value of Annaly’s mortgage service rights as of September 30 was just over $ 660 million, or less than 1% of her total investments, compared to 29% for NRZ. For the context, the fixed-rate securities of NLY’s agencies have an estimated fair value of $ 62.5 billion; An additional $ 23.6 billion in TBA (which will likely be mostly fixed rate); and $ 8.4 billion in its residential credit portfolio.
In recent times, results have been similar to AGNC’s, with book value falling as interest rates have inflated in 2021.
It also shares another unfavorable trait with AGNC:
Annaly also has experience in dividend reduction
Huge dividends you can count on for decades
This is, in a nutshell, one of the most serious dangers of investing in super high yielding stocks:
They have too many “buts”.
- Nice return … but rising rates will tear it to shreds.
- Big payout … but it’s still cut, not increased.
- What a dividend … but the stock swings like Tarzan.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.