What Time is it in the Land of REITs?
Alexander is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In the investment world continuing double digit returns are sought by many but found by few. When a company can offer dividends in this range too many investors jump on board without fully understanding what they are investing in and often get burned in the end.
What's a REIT?
REITs are a way for investors to collect double digit dividends but they come with their own set of risks. While some REITs invest in actual real estate by buying and renting properties, the types of REITs offering such high yields primarily invest in mortgage related securities. This article is devoted to discussing the second type of REIT. Not only do these REITs purchase mortgage backed securities, but they make their profits by leveraging these securities using borrowed money.
One may question what would possess a company to leverage money to buy these instruments after the disastrous effects they've had on the economy and the companies that invested in them. But most REITs invest in higher rated instruments which have a lower chance of default than the sub-prime loans from the mortgage meltdown. On the other hand, some REITs, such as Chimera Investment , are more adventurous and purchase lower rated securities in an attempt to widen their spread between borrowed funds and security yields.
Most REITs make their profits by borrowing at the dirt cheap interest rates and buying higher yield securities with the money. However this results in a large amount of debt overhanging the company for as long as the strategy continues. For example, one of the most popular mortgage REITs, Annaly Capital Management (NYSE: NLY), has a debt to equity ratio of 6.1X. Some others have even higher debt levels. ARMOUR Residential REIT (NYSE: ARR) has a debt to equity ratio of 8.9X.
The Clock is Ticking
In an ultra-low interest rate environment such as this REITs thrive by borrowing large amounts of money but when rates go up, the spreads between borrowing costs and security yields rapidly decrease. For many REITs, this could create a cash squeeze that could result in a stock crash or even bankruptcy. The companies may choose to save themselves by quickly printing shares to raise capital, thus diluting existing shareholders. Either way, when rates increase the effect on current shareholders will be disastrous.
At this point the Federal Reserve is showing no signs of raising rates and intends to keep them low until at least 2014. Many REITs have yields around 15 percent meaning it would take less than seven years to double one's money, even with no dividend reinvestment. If the economy remains stagnant, interest rates could remain low for years allowing original investors to reap a 100 percent return on their initial investment, after which any gains would be pure profit.
But many think the Fed would be forced to raise rates within the next five years to avert possible inflation thereby threatening the yields of mortgage REITs. Additionally, any stable sign of economic turnaround could cause the Fed to raise rates meaning. REITs would require years of economic stagnation. If the Fed does intend to raise rates, it would be up to investors to call midnight on a potential REIT collapse. Before the 2008 collapse, many top level traders believed they could do the same thing with mortgage backed securities made up of sub-prime loans. As we saw during the crisis, many failed to do so and it cost them dearly and wiped out entire firms in the process.
Getting out in time may require missing an upcoming dividend payment to sell the stock before midnight. Like most American stocks, REITs generally pay their dividends on a quarterly basis increasing the chances an investor may be forced to miss a dividend payment to avoid a REIT collapse. ARMOUR Residential pays its dividend on a monthly basis, but also has among the high debt to equity ratios meaning it could be one of the first to fall.
You Got the Time?
Calling midnight is much more difficult than it sounds but is essential to REIT investing. One day shareholders of these companies will be burned either by dilution, lack of earnings, or bankruptcy. The question is when. Anyone who can successfully call the end of the party could make enormous gains in the process. However, those who do not think they can should just stay out of the way of the incoming carnage.
Alexander MacLennan does not currently own shares in any of the companies mentioned in this entry. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.