One of the best ways of investing for income is through real estate investment trusts (REITs), which have holdings of mortgages. But many income-seeking investors avoid REITs because of the erroneous perception that the volatility of the price of the REIT indicates risk to the income stream it produces.
This is the first of several columns in which I will examine the macro economy's relationship to the real estate industry and the probable performance of real estate investment trusts and their ability to continue to deliver secure income to investors.
The performance of the price of a mortgage REIT is directly correlated with the direction of long-term Treasury yields. REITs are most sensitive to yields on Treasury maturities in the seven-to-10-year range. This has nothing to do with the income produced by the REITs, which I will address in a bit.
The reason for the price sensitivity to Treasury yields is that the underlying market value of the mortgages that the REITs are invested in moves inversely to Treasury yields. If the 10-year Treasury yield rises, the market value of the existing mortgages held by a REIT decreases, and vice versa.
Speculators understand this relationship, and since they have no interest in the income-producing purpose of the REIT, they will game the market value of the REIT's share price up and down, depending on what they expect Treasury yields to do and what rates actually do. Again, this movement in the REIT's price has very little to do with the ability of the REIT to continue to deliver income, and speculators are not gaming the REIT's price on expectations of a change in the income that may be delivered to investors.
Many income investors, however, get spooked by the volatility in the share price and assume that this movement in some way indicates the stability of the income a REIT may receive and pass on to investors. This leads to REITs providing yields that, in comparison with other income-producing vehicles, may be unusually high. This too can spook income investors into staying away from REITs, in keeping with the old refrain that if it looks too good to be true, it probably is.
There are different types of mortgage REITs, which I will review in more detail in future columns, but they fall into two basic categories: residential and commercial. They may be refined further into leveraged and unleveraged, agency and non-agency, as well as those investing in second trusts and derivative products.
For the most part, mortgage REITs are investing in first trust residential agency-backed mortgages and the derivatives of them.
The new rules and regulations concerning underwriting criteria that lenders must meet when making a residential mortgage are far more stringent than they were prior to the 2008 crisis. The potential for losses occurring as the result of mortgagors defaulting has been greatly reduced as a result of these new stringent underwriting guidelines.
Investors in mortgage REITs, however, are still pricing them as though the risks of losses are similar to what they were before the devolution of underwriting guidelines that led to the housing bubble, stock market crash and demise of Lehman Brothers. This is unwarranted.
In the past six months, the market prices of many REITs have declined dramatically as the yield on the 10-year U.S. Treasury has surged on expectations by bond traders that the Federal Reserve was preparing to begin to slow its purchases of mortgages.
Annaly Capital Management (NLY) is trading at about $10, down from about $16 in May and even well below the $12.88 low it set in early 2009, as a result of the financial crisis. The decline in the price has occurred concurrently with the rise of long-end Treasury yields, but the income produced as a result of mortgage payments being passed through the REIT to investors remains secure. At the $10 price, the dividend of $1.40 produces a yield of 14%.
Another similarly sized mortgage REIT, American Capital Agency (AGNC), is currently priced at about $20, down from the $33 level of last May, and produces a yield of about 16%!
Another large mortgage REIT, about one-third the size of Annaly and half the size of American Capital Agency, but still large with a market cap of about $3 billion, is Chimera Investment (CIM). It's currently priced at $2.96, with a dividend of $0.36, producing a yield of about 12%.
All three of these REITs are large and diversified and have a concentration in first trust residential mortgages. For income-seeking investors who can hold for the long term, the temporary impact of Treasury yield changes on the market price of the issues has created fantastic opportunities.