Mortgage REITs Make Long-Term Sense

 | Dec 09, 2011 | 1:30 PM EST  | Comments
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One of the keys to the U.S. economy is real estate. The rest of the economic data is mostly noise. If real estate prices firm, banks will no longer be afraid to lend on collateral with falling value, and consumers' fears of losing their homes or being underwater on their mortgages will abate. Along with job growth, real estate prices are what really matter on the domestic front. The mess in Europe will hit Wall Street, but on Main Street, real estate and jobs are most important.

According to the most recent Case-Shiller report, home prices are not falling as fast as they were, but they are still falling. In spite of this continued decline, I have been enthusiastically suggesting that long-term investors look at real estate-related securities. The continued price declines have created opportunities. Consistent with the overall trend, they may get cheaper before pricing improves, but the pricing of many real estate investment trusts and real estate operating companies creates the potential for long-term upside in multiples, not percentages, for patient investors.

Let's look at my past suggestions for mortgage REITs, as well as new securities that will see substantial appreciation when the markets finally improve. The high yields of many mortgage-backed investments look very attractive in today's market, and the pricing of many is cheap. My one concern is that the yields are so tempting that investors will overload their portfolios. Whenever I talk mortgage-backed REITs, I mention stating small, moving slowly and not over-allocating to this higher-risk brand of REIT. They have their place in a long-term portfolio, but for most investors that should not be a dominant percentage.

One of my favorite company's in the space is Invesco Mortgage Capital (IVR). It's seen its book value drop this year, and it recently announced a reduced dividend payout of $0.65 per share for the fourth quarter. Like most Mortgage REITs, the company is feeling some pain form tighter spreads. Elements of fiscal policy such as the "twist" bond-buying program have pushed long-term bond yields down this year. Mortgage modification and repurchase programs have also pressured yields on mortgage-backed securities and hurt payouts for the company.

Invesco is advised by WL Ross & Co., and having the distressed-investing firm on board gives Invesco a long-term edge. I have mentioned before that I have never lost money investing in situations where Wilbur Ross was involved. That will be the case here, as well. Keep in mind, however, that my average time involved in Wilbur Ross deals easily exceeds five years. This is not a short-term idea. I have owned this stock for two years, and while the price has dropped about 25%, I have collected slightly more than that in dividends, so I am up overall. I expect a very bumpy and very profitable ride in Invesco.

Annaly Capital (NLY) continues to be one of the best run, most conservative mortgage REITs. Although it's been hit by the same tightening spreads as others in the group, Annaly has offset some of this by expanding its asset management division. It currently has more than $12 billion of outside assets under management, which generates more than $80 million a year in fees. As spreads have tightened, management has reduced the leverage employed in its agency-backed mortgage purchases, and that has reduced the portfolio's risk. The REIT buys government-backed mortgage securities, so credit quality is not the risk for Annaly that it might be for other mortgage REITs. Buying this REIT on weakness should pay long-term dividends for patient investors.

Mortgage REITs face substantial headwinds right now. In addition to mortgage prepayments and tighter spreads, there have been rumbles about changes in tax status and new regulations. In the long run, mortgage REITs will be very profitable. As always, don't allocate too much of your portfolio to these volatile securities, and make the market work for you buy moving slow and staying small.

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