COLUMN-Mortgage REITs offer double-digit yields, bigger risks

Reuters

By Conrad de Aenlle

LONG BEACH, Calif., Sept 25 (Reuters) - The Federal Reservepleasantly surprised the markets last week when it chose not tostart curtailing debt purchases.

While bonds rallied overall, an obscure type of asset calledmortgage real estate investment trusts reacted especially well,with some gaining 5 percent or more in the hours after the Fed'sSept. 18 announcement.

Mortgage REITs hold portfolios of property loans, and thatmakes them acutely sensitive to swings in interest rates.Mortgages, like many fixed-income instruments, rise in valuewhen rates fall and vice versa. Rate changes can make housingmore or less affordable, affecting homeowners' ability to keepup mortgage payments. Most important, because mortgage REITstypically use leverage - borrowing cheaper short-term money tomake more loans than they could with their own equity - theimpact of the first two factors is amplified.

That's why mortgage REITs soared after the Fed announcement,but it's also why they plunged after the Fed hinted in May thatit was considering reducing debt purchases. Between May 17 andAug. 19, the Market Vectors Mortgage REIT Income ETF fell 24 percent. It has since clawed back about a third of thoselosses.

Shareholders in mortgage REITs do not endure such volatilityfor nothing. The leverage that is so common in the sector oftenproduces spectacular yields, such as 11 percent on the MarketVectors ETF.

That's not enough to make up for the summertime loss, butfans of mortgage REITs contend that the selling was overdone andthey encourage investors to consider owning them - but only onesthat limit risk in one way or another.

James Kieffer, lead manager of the Artisan Mid Cap ValueFund, views mortgage REITs as "yield-manufacturingdevices" that can boost the income of a broad investmentportfolio. The two that he holds, Annaly Capital Management Inc and Hatteras Financial Corp, had recent yieldsof 12.4 percent and 14.2 percent, respectively. He prefers themto other REITs in part because they own onlygovernment-guaranteed mortgages, which essentially eliminatesdefault risk.

Kieffer, whose fund has outperformed its mid-cap category by3.5 percentage points a year for the last decade, according toMorningstar, decided to be a more careful manager about a yearago.

Perhaps the biggest risk to the value of mortgage REITS is asharp rise in interest rates. Kieffer sold about 40 percent ofhis mortgage REIT holdings after rates went to all-time lows andseemed likely to him to reverse course. He was right, althoughhe said the extent of the decline caught him off guard, and heacknowledged increasing his positions, which he did early thissummer, too soon.

When they did fall, mortgage REITs fell hard, and shareprices dropped by more than could be accounted for by declinesin their intrinsic value as interest rates rose. Price-to-bookratios fell, too. Annaly's price has fallen in the last 12months from 1.08 times book value to 0.91, meaning the REIT canbe bought for less than the market value of its loans. Hatteraslikewise has gone from 1.08 times book to 0.87.

The rate risk that owners of residential mortgage REITs takeon is something that Joel Beam, manager of the Forward SelectIncome Fund, would like to avoid. He favors REITs thathold loans on commercial property.

Beam's portfolio, which Morningstar ranks as the bestfive-year performer among real estate funds, owns Ares CapitalCorp (ARCC.O ) and several preferred shares issued by iStarFinancial Inc. Preferred shares rank higher than common stock ina company's capital structure and, similar to bonds, are deemedto be safer but have less appreciation potential.

Beam says iStar and Ares use less leverage than residentialREITs, and he particularly likes iStar because its executiveshave considerable expertise in real estate management. "If aloan goes bad, they can take back the collateral andmanage it," he said.

Commercial mortgage REITs borrow less, but they still havehealthy yields, albeit smaller ones than their residentialcounterparts. Ares recently yielded 8.6 percent, and the fiveiStar preferred series had yields between 7.6 percent and 8percent.

Expressing his disdain for residential mortgage REITs, Beamsaid, "I see them as very highly leveraged, four, five, sixtimes. That worries me now when there's a lot of interest raterisk in the world. Their book values can change fast."

That worries Kieffer less. He concedes, though, that owningresidential REITs can entail more rate risk than many investorscan handle, so he recommends taking only small positionsrelative to the size of one's total portfolio.

"In the environment we're in and continue to be in, where weare likely to have low rates for a long time and anupward-sloping yield curve, they're a device that works as itwas meant to," Kieffer said.

But he also warned, "These things can explode overnight onyou. They're appealing vehicles with moments of volatility andfright in them."

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