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Income Investing

Mortgage REITs: High Yields, Big Risks

By Roger S. Conrad, on Mar. 30, 2015

Mortgage real estate investment trusts (M-REIT) hold portfolios of mortgage-backed securities.

Whereas property-owning REITs seek to maximize rents and occupancy rates on their real estate while controlling operating, maintenance and borrowing costs, an M-REIT’s performance hinges on management’s ability to anticipate and prepare for credit and interest rate risk.

M-REITs tend to fare better when the economy is on solid ground, as the credit risk associated with their holdings tends to decline. These names can also post strong returns in a rising-rate environment, provided that management has hedged appropriately. Over time, higher interest rates will bolster the yields on mortgages, increasing the cash flow generated by new securitizations.

To pump up yields, M-REITs often use leverage. These factors explain why the nine M-REITs in our table sport an average yield of more than 10 percent at a time when interest rates on even the longest-term mortgages are less than half this amount.

M-Reit Table

Unfortunately, the robust yields come at a cost: the risk of not knowing exactly what the M-REIT owns and whether management has prepared adequately for any adverse shifts in market conditions.

Putting your money into these black boxes involves trusting the people in charge to make the right moves at the right times. The record shows that such assumptions can be dangerous. For example, when credit markets seizes up in 2008, M-REIT suffered mass bankruptcies and liquidations.

And despite the relative stability of the past several years, Redwood Trust (NYSE: RWT) is the only M-REIT in our table that hasn’t cut its dividend over the past two years. This resilience reflects the conservative payout policy that management instituted after the M-REIT in April 2009 slashed its quarterly dividend to $0.25 per share from $0.75 per share.

In fact, all the other names on our list have reduced their quarterly payouts since August 2013, when we last surveyed the M-REIT space (see Risky, with a Chance of Dividend Cuts).

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