By The Sick Economist
Let’s go for an imaginary car ride. We are going to cruise through some residential neighborhoods filled with single family homes. What do you see? Green lawns and children playing? Neatly arranged stacks of bricks with immaculate paint and sturdy roofs? When I look at a residential neighborhood, all I see is dividends. Every time these folks make a mortgage payment, I get a piece of it. That is because I own mortgage REITs, (mREITs). Long story short, the mortgage debt of the average American family is one of my best paying investments. You can also benefit from America’s obsession with home ownership.
When most people refer to REITS, they refer to organizations that own tangible real estate, which are technically referred to as equity REITs. Equity REITs are corporate entities with special rules that own real estate. Traditional equity REITs own the actual bricks and mortar. Mortgage REITs own the debt associated with real estate. Equity REITs own physical assets, whereas mREITs just own piles of paper.
For many people, the lack of physical assets is off putting. Your typical equity REIT pays between 3 and 6% dividends quarterly, while your typical mREIT pays between 8 and 12% dividends monthly. Mortgage REITs are like financial rocket fuel that can help your retirement soar. However, to the novice investor, they feel risky. If the returns are so high, and the assets aren’t even tangible, is it really safe to count on these vehicles for steady retirement income?
If history is any guide, mREITs are a lot safer than they seem on the surface. Annaly Capital Management, the largest mREIT that invests in single family mortgages, has paid a steady dividend every month since 1997. This means that the company weathered at least three stock crashes and the mother of all real estate crashes in 2008 and still never skipped a dividend. Annaly’s principal rival, AGNC Investment Corp, can say almost the same. They have been paying steady monthly income for twelve consecutive years. In our latest coronavirus crisis, no major mortgage REIT went bankrupt; a few did trim their dividends, but now those dividends are quickly rebounding.
How can a security pay out 10% month after month with so little risk? To understand the risk profile of the mREIT sector, you need to understand how these companies work, and why they exist.
Simply Complex
Did you know that the American system of home ownership is utterly unique in the world? In most countries, there is no such thing as a thirty-year mortgage. Additionally, in many countries, you need a much larger down-payment to buy a house. 50% down, up front, is not uncommon. The idea that an average Joe could buy a house with just 20% down, or 10% down, or even 5% down is uniquely American. In fact, it’s not just an unusual system. It’s an unnatural system.
When I say unnatural, all I mean is that the American homeownership system is the direct result of massive government intervention. No private lender would ever lend $400,000 to a middle class family where both partners have to work to pay the mortgage, and the family is only one job loss away from default. Even if a private lender would make such a risky loan, they certainly wouldn’t do it at today’s absurdly low interest rates.
The reason why an average American family can get a mortgage, even with just 5% down and a shaky income situation, is because the Federal Government removes the risk for lenders. That’s right, in the vast majority of American mortgages, the lender can’t lose because the Federal Government has guaranteed the loan. You wouldn’t want to lend large amounts of money at low interest rates to barely solvent families if you bore the true risk. But if you could lend the money with virtually no risk, then you might do it.
I say “might,” because even with federal guarantees, lending large amounts of money at low rates over long periods of time is not very sexy. Your risk would be low, but so would your reward. It’s asking a lot of a bank to tie up billions upon billions of dollars at 4% interest for decades. So our system has evolved into a situation where most banks simply originate loans. Meaning they go through the time and trouble of building a sales, marketing, and mortgage processing machine, but they don’t actually hold the loans at those low interest rates. After they originate the loan, they take the fees, and then sell the loan to someone else.This allows the entire mortgage business to become a fee generation machine for big lenders. They collect fat fees, collect a little interest, sell the loan, and then use the same money all over again to repeat the process. Even with no risk, the interest rates still suck; it’s the constant fees and the recycling of money that makes mortgage origination a good business. If the originators could not sell the loans they make, the entire system would ground to a halt.
Which is why mortgage REITs have had such a steady track record. Mortgage REITs buy loans from originators. They don’t buy the loans directly. They buy what are called Mortgage Backed Securities, or MBS. Each MBS represents hundreds or thousands of loans that were originated by banks, then packaged and sold to investors as bonds. Mortgage REITs are some of the largest buyers of MBS in the United States. These MBS are fully guaranteed by the Federal Government. The largest, most brand name Mortgage REITs focus on buying Mortgage Backed Securities that are explicitly guaranteed by the Federal Government. The magic of the mortgage REIT is that, when you are the largest buyer of government backed securities, you also have the implicit backing of the Federal Government. Remember, the entire Frankenstein’s Monster of a system only works if someone keeps buying the Mortgage Backed Securities that originators create.
Banks and other large lenders originate loans and then sell them, because the characteristics of the loans aren’t too sexy. So how can mREITs take a lame 3% interest 30-year loan and transform it into an attractive 10% monthly yield?
The magic that turns lead into gold is leverage. Mortgage REITs borrow money on a short term basis at very low interest and invest that money on a long term basis in the form of mortgage backed securities. The difference between the interest they receive on the mortgage backed securities and the interest they must pay on the short term borrowings is called the Net Interest Margin.
The fact that mortgage backed securities are explicitly backed by the Federal Government means that they are great collateral. You can borrow heavily against them. mREITs use large amounts of leverage, and that is how they wind up squeezing so much juice from a rather unappetizing fruit.
While mREITs are a crucial pillar of American housing, there is still some risk for an investor. The main risk comes in the form of interest rates. The amount of money that an mREIT makes is dependent on that net interest margin, or the difference between long-term and short-term interest rates. The movement of interest rates can be arcane, and at times hard to predict. That is why mREITs are less common than fast food or dry-cleaning businesses. However, an experienced management team does have a large toolkit to manage these interest rate risks.
Be aware, not all mortgages are guaranteed by the Federal Government, and not all mREITs exclusively buy loans guaranteed by the feds. There are a few extra risky mREITs that specialize in non-guaranteed loans. These are called non agency REITs. But most of the largest names in the business focus exclusively on the conforming FHA loans; the bread and butter of middle class housing. REITs that exclusively buy mortgages backed by the Federal Government are referred to as agency REITs. If you are a conservative investor, I would stick to large, long-established agency REITs such as Annaly Capital, AGNC, or an exchange traded fund that specializes in mortgage REITs, such as iSHARES Mortgage REIT Real Estate fund (REM) or VanEck Vectors REIT Income ETF (MORT).
Never Fear, mREIT Is Here
For the longest time, I couldn’t get over the fact that a mortgage REIT was just a pile of paper. It just didn’t feel solid to me. But history tells us something different.
If you lived through the Great Recession, you know that it seemed like the entire house of cards was about to tumble down. There had been all kinds of excesses related to mortgage backed securities. It seemed like everyone was getting foreclosed upon, and American housing would never be the same. Everyone said that there had to be reforms; surely big changes were in the works.
That prognostication turned out to be totally incorrect. Twelve years after the real estate crisis to end all real estate crises, what has changed is… nothing. Well, almost nothing. For a long time after the crisis, it was tougher to get a mortgage. Down payment requirements increased. Credit score requirements increased. But now it’s almost like the whole thing never happened. I recently had a friend who bought a house with just 5% down. I even know people who went into foreclosure in 2009 who have now bought houses all over again, once again with just 5 or 10% down.
During the worst of the mortgage crisis, few mREITs went bankrupt. In fact, most never even stopped paying a dividend. The fundamentals of our housing system today remain unchanged from 2008. And mortgage REITs are a critical element of those fundamentals. Without the liquidity created by mREITs, millions of middle class people would be unable to own a home. The Federal Government has demonstrated an absolutely ruthless resolve to keep the home ownership contraption alive, even if it remains dependent on government life support. When you bet on a mortgage REIT, you are betting that American society will continue to prize homeownership, and that politicians will do just about anything to keep voters happy.
mREITs have transformed my financial plan. They pay a steady dividend every month, allowing me to plan my life around my monthly “paycheck.” I am not particularly risk averse, so most of my mREITs invest in government-guaranteed mortgages, but I do own a few smaller mREITs that invest in non-conforming loans or more specialized niches.
On average, mortgage REITs yield double what most dividend stocks yield. However, be aware that most of the value of mREITs is in the dividend yield. So, for example, a regular equity REIT may yield 4%, but return a total of 11% with share price appreciation over the years. A mortgage REIT may pay out 10% every month, but the share price may not increase much. So, even though the equity REIT pays out less, it may offer larger total returns over the long run. Thus, a well diversified portfolio of income producing equities remains recommendable.
The math and the concepts behind mortgage REITs may seem complicated at first. If you choose to study the industry, you will learn your way, just like any other business. But you only need a simple understanding in order to dramatically increase the yield on your equity portfolio, and dramatically decrease how much you need saved for retirement.
mREITs invest in mortgage debt, and American society is highly dependent upon these entities to continue the tradition of homeownership. mREITs pay monthly, and the payouts can vary depending on trends in interest rates. With that little bit of information, you can increase your monthly income a lot.
1 thought on “MORTGAGE REITS: HIGH YIELD FROM HOUSES”
Comments are closed.