Despite exceptional yields, mortgage REITs have underperformed equity REITs over the past 5 years. As a retiree looking for income, I was drawn to the mouthwatering yields offered by Mortgage Real Estate Investment Trusts (mREITs).
We only use your contact details to reply to your request for more information.We do not sell the personal contact data you submit to anyone else. Over the past 7 years, domestic REIT CEFs have exhibited excellent risk-adjusted performance, with a few actually outperforming the S&P 500. For the past several years, I have written extensively about the Fed’s dangerous efforts to drive interest rates low enough to stimulate a stronger recovery.  As a consequence, large and small investors have been compelled to go out on the risk curve in a desperate search for higher yield. Lured by almost irresistible double-digit yields in 2012 and early 2013, investors dived into mortgage REITs with abandon.  Having discussed the serious risks of equity REITs in my previous article , now is a good time to examine whether mortgage REITs pose similar risks for the unwary. Because the REIT is able to buy RMBS tranches that total many times its equity through borrowing, the dividend that this leverage throws off to investors is magnified.  So a dividend yield of 12-18% seems too good to pass up for many investors. A second factor that has been almost totally disregarded is the serious delinquency problem with their mortgage portfolios.  This is especially true with American Capital Agency (AGNC), Two Harbors Investment (TWO) and Invesco Mortgage Capital (IVR). Non-agency mortgage-backed securities hold mortgages that are not guaranteed by Fannie Mae or Freddie Mac nor insured by the Federal Housing Administration (FHA).  Nearly all of them were originated prior to early 2007 when the sub-prime mortgage market collapsed. Let’s take a look at the portfolio of one of the large mortgage REITs that is loaded with these non-guaranteed RMBS – Two Harbors Investment Corp. It isn’t that simple.  To comprehend the risks of default in any RMBS piece (known as a tranche), you have to find out as much as possible about the characteristics of the mortgages housed in it. Mortgage applications are relevant to a number of industries—from banks to non-banks, to mortgage REITs to homebuilders.
This weekly piece is useful to help investors forecast activity for the homebuilders, like Lennar (LEN), KB Home (KBH), and Standard Pacific (SPF), as well as assess prepayment risk for mortgage REITs, like American Capital Agency (AGNC) and Annaly Capital (NLY). This series will look at the three main MBA indices. We’ll start with the basic MBA Mortgage Applications Index.
Rather than investing in individual REITs, I prefer REIT funds, especially Closed-End Funds (CEFs) because of their high distributions, typically between 6% and 8%. Bart Wisniowski, founder and CEO of Advisor Websites, has the best seat in the house to watch the rapidly evolving state-of-the-art in website design and feature sets in this age of social media, video blogs and smartphones.
This series will break down the different indices and help you learn what insight you can glean from them. In a recent interview, Wisniowski not only talked about the latest developments and trends that he’s seeing; he also identified some of the advisory profession’s most interesting and creative websites. If you’re a bank, you’re looking at these indices and trying to determine whether you’re competitive in all the segments you want to be competitive in.
Therefore, I decided to analyze mREITs to assess if the yields translated into high total return and to determine how much risk I had to assume to reap the rewards. Before I provide the results of my analysis, I thought it might be productive to review some of the characteristic of mortgage REITs.In 1960, Congress created a new type of security called REITs that allowed real estate investments to be traded as a stock.
If you’re a mortgage REIT, you’re focusing on the refinance index and what it might mean for prepayments going forward.
The objective of this landmark legislation was to provide a way for small investors to participate in the income from large scale real estate projects. And if you’re a homebuilder, you’re watching the purchase index as a way to gauge future demand. A REIT is a company that specializes in real estate, either through properties or mortgages.
Along the way, I will also compare the REIT CEFs to Exchange Traded Funds (ETFs) and to the general stock market.
There are two major types of REITs:Equity REITs purchase and operate real estate properties.
However, before jumping into the analysis, it will be useful to review some of the characteristics of this asset class.In 1960, Congress created a new type of security called REITs that allowed real estate investments to be traded as a stock. About 90% of REITs are equity REITs.Mortgage REITs invest in mortgages or mortgage backed securities.
Income is generated primarily from the interest that is earned on mortgage loans.The risks and rewards associated with mortgage REITs are very different than those associated with equity REITs. There are two major types of REITsEquity REITs purchase and operate real estate properties. Equity REITs were covered in a previous Seeking Alpha article so this article will only consider mortgage REITs.An mREIT is a company that invests in real estate mortgage debt. Even though most mortgages are originated with banks, many banks sell them on the secondary market, usually to mortgage REITs.

About 90% of REITs are equity REITS.Mortgage REITs invest in mortgages or mortgage-backed securities. These mortgages are secured by federal agencies such as Fannie Mae, Freddy Mac, or Ginnie Mae.
This article will only consider equity REITs.One of the reasons REITs are so popular is that they receive special tax treatment, and as a result, are required to distribute at least 90% of their taxable income each year. Since these mortgages are backed by federal guarantees, the risks of default is very low and consequently the yield is also low.Non-agency mortgages. The income from these mortgages tend to be higher because of the increased risk of default.One of the reasons REITs are so popular is that they receive special tax treatment and as a result, they are required to distribute at least 90% of their taxable income. Because of this 90% rule, mREITs typically borrow money on a short-term basis to purchase additional long-term mortgages. If the interest rates rise, the cost of debt increases and the REIT has less money for business investment.
In order to make a profit, the income from the long-term mortgages must be greater than that the short-term borrowing costs. The difference between long term and short-term rates is called the spread (and is also shown illustrated by the treasury yield curve).
The cash available for distributions comes from interest, dividends, and realized capital gains made in the current period.
In addition to playing the spread, mREITs also use leverage (as much as 10 times or more), so when the spread is high, mREITs can make enormous profits that are passed to shareholders as extraordinary distributions. However, if spread narrows, then profits will dwindle and the stock prices can plummet.Currently funding costs are low since short-term rates are near zero. However, mortgage rates have also been at generational lows, falling to around 3.5% last December. When it comes time for a distribution, a fund manager may decide not to sell some of his best performing assets because he believes they will appreciate even more. Mortgage REITs suffered a sharp decline in 2013 with the price of many companies falling 18% or more.
This selloff was driven by fear that interest rates would rise and reduce the spread.There are more mREITs than I can analyze in one article so I have chosen some of the more popular companies and Exchange Traded Funds.
Annaly invests primarily in agency backed mortgages and at the end of 2013, the portfolio consisted of 91% fixed rate securities with the rest in adjustable rates. This CEF sells for a small discount of 5.1%, which is unusual since over the past 5 years the fund has sold at an average premium of 4%. Annaly is being cautious with regard to a potential interest rate rise by only using about half the available leverage. The REIT's holdings are spread over all types of properties (residential, commercial, retail). As with most REITs, the price of the fund dropped over 60% in 2008, but rebounded strongly in 2009, gaining 89%. The fund utilizes 30% leverage and has an expense ratio of 1.8%, including interest payments. The portfolio consists of the following types of mortgages: 65% of 30 year fixed rate, 30% of 15 year or less fixed rate, and 2% of 20 year fixed rate. The fund consists of 66 holdings with 66% in diversified REITs and 33% in preferred shares. The fund uses leverage of 25% and has an expense ratio of 2.1%, including interest payments. The fund utilizes 26% leverage and has an expense ratio of 2%, including interest payments.
The fund trades on average more than a million shares per day and has a spectacular yield of 12.5%.
This ETF was launched in 2004 and tracks the MSCI US REIT Index, which is a pure equity REIT index.
The portfolio consists of 63 securities with 95% in REITs and the rest in preferred shares. The index is diversified across real estate sectors with retail being the largest constituent at 27% followed by Office (15%), residential (15%), and health care (15%). About 49% of the holdings are from the United States with the rest spread over Asia, Europe, Australia, and Canada.
The fund charges a miniscule 0.10%, which is substantially less than most of its competitors.
This ETF tracks the S&P 500 and will be used to see how mREITs performed relative to the broad stock market.

To answer this question, I calculated the Sharpe Ratio.The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. The fund uses only a small amount (8%) of leverage and has an expense ratio of 1.3%, including interest payments. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with Vanguard's REIT Index. This ETF tracks the S&P 500 and will be used to see how REITs performed relative to the broad stock market. To assess the degree of diversification, I calculated the pair-wise correlations associated with the mREIT companies and the reference ETFs. To capture the entire bear-bull cycle, I used data from October 12, 2007 (the market high before the collapse) until today (a period of a little over 7 years). Correlation matrix over the past 5 yearsAs is apparent from the matrix, the addition of mREIT companies to an equity portfolio provided excellent diversification (correlations were only 30% to 50%).
Somewhat surprising, mREITs also provided excellent diversification against an equity REIT portfolio. Bottom line is that mREITs lived up to their reputation for diversification.Next, I looked at the past 3 year period to see if the mREIT performance had significantly changed. Over the past 3 years, the SPY has been in a rip-roaring bull market and outpaced all the REIT funds. The past 12 months does not include this bear market and performance during the recovery has been outstanding.
In fact, over the last year, REITs in general and mREITs in particular have outperformed SPY. It is interesting to note that REM, VNQ, and CIM all has the same risk-adjusted performance. These three securities were the best performers but all the mREITs had better risk-adjusted performance than the general stock market.(click to enlarge)Figure 4. To assess the degree of diversification, I calculated the pair-wise correlations associated with the REIT funds and the SPY. Correlation matrix over bear-bull cycleAs is apparent from the matrix, REITs did provide a reasonable amount of portfolio diversification.
As can be seen from their performance in 2013, mREITs can be a loss leader but when they are hot, they are hot (like this year). Somewhat surprising, the CEFs were also not highly correlated with each other or with the REIT ETF (with correlations ranging from 60% to 80%). They do provide excellent diversification so if you are risk tolerant, they could provide a good addition to your portfolio. As you might expect, the Cohen and Steers REIT funds were more correlated with each other than with others funds, but they still offered relatively good diversification.Next, I looked at the past 3-year period to see if the REIT performance had significantly changed.
However, several funds (NRO, RNP, VNQ, and RQI) almost kept pace with SPY on a risk-adjusted basis. The performance of all the REIT funds were rather tightly bunched, but RNP and NRO had the best performance and beat VNQ. The global REITs still lagged and were only able to outperform JRS on a risk-adjusted basis.(click to enlarge)Figure 3.
Reward for REIT funds over past 3 yearsAs a final test, I re-ran the analysis over the past 12 months.
Over the last 12 months, several REITs have been on fire, easily beating SPY on a risk-adjusted basis. Only the global CEFs (IGR and AWP) and JRS lagged during this period.(click to enlarge)Figure 4.
Reward for REIT funds previous 12 monthsBottom LineI don't know if REITs will continue their outperformance in the future, but REIT CEFs have provided both good performance and diversification over the past 7 years. If you are a risk tolerant investor and looking for real estate exposure, I believe that RNP, RQI, and NRO are good choices to spice up your retirement portfolio.

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