Of course, that Main Street anxiety hasn’t been relegated to home prices…

Real estate-related investments have similarly been held underwater in the last few years as investors on and off Wall Street have avoided premature exposure to this sector. Among the hardest hit have been real estate investment trusts, or REITs. With exposure to things like commercial real estate project, mortgages and exotic debt instruments, who could blame investors for shying away from these stocks? They’re scary — maybe scarier than housing.

But most investors don’t realize that REITs don’t really provide exposure to the real estate market — and they’re not designed to.

Instead, REITs are designed to be income-generation vehicles that remove nearly all of the risks of their underlying assets. Landlord REITs almost universally rent out their properties with long-term triple-net leases that lock in rental rates (with regular increases) and take away tax and maintenance liabilities. Landlord REITs have exposure to real estate in only the most long-term, roundabout sense. Their distant cousins, Mortgage REITs, work in much the same way, owning incredibly safe mortgage investments that essentially strip away exposure to real estate and borrowers.

So what kind of “safe” investments do mortgage REITs own? Typical portfolios are made up of a variety of mortgage-backed securities (MBS) and collateralized mortgage obligations (CMOs) — the same scary three-letter securities that are blamed for the mortgage meltdown in 2007 and 2008. But before you close your browser window, let me explain exactly why that’s a good thing for your portfolio in 2011…

For starters, while they share the same name, the types of MBSs that most mortgage REITs invest in aren’t nearly the same kind of investments that took down the real estate market in years past. Instead, financially stable firms invest almost entirely in agency securities, which are backed by the full force of the U.S. government. Put simply, mortgage defaults don’t matter for these investments.

What does matter is how long most mortgages last.

You see, mortgage REITs make their money by taking advantage of the difference between short- and long-term interest rates. Because there’s more risk (and more opportunity cost) in lending money to someone for a longer period of time, long-term interest rates are normally much higher than short-term rates. By taking on short-term borrowings to fund their long-term mortgage investments, these firms take advantage of a leveraged spread with essentially no credit risk.

So while the term “mortgage REIT” sounds like it has a lot to do with the housing market, these investments are actually a way to play interest rates. And because REITs are required to pay out the vast majority of their incomes to shareholders as dividends, the income generation at these firms is substantial.

Implications of Higher Interest Rates

Until recently, there’s been very little volatility in the interest rate world. With the U.S. economy knee-deep in a recession, the Fed’s top priority has been to keep rates as close to zero as possible in order to stimulate borrowing. But now, as the recovery begins to get a bit more mature, increasing murmurs on Wall Street are pointing to the possibility of rate hikes in the near-to-intermediate term.

That uncertainty has already been priced into most interest rate-sensitive stocks.

Even so, it’s not interest rate hikes that are a concern for mortgage REITs — instead, it’s the rate of change between long- and short-term rates that is crucial. If short-term rates climb faster than long-term rates, the liquidity spread shrinks and mortgage REIT profit margins get squeezed.

There are a handful of attractive small-cap REITs on the market right now – and most share these core characteristics. If you’re looking for a dependable income stream, make sure that the firm you’re looking at primarily invests in agency-backed securities. If that’s the case, it’ll behave like the rest…

Sincerely,
Jonas Elmerraji
Penny Sleuth

April 28, 2011

Ride REITs to Profit in 2011 was originally featured in the Penny Sleuth.

Yet the stocks of real estate investment trusts (REITs), which are popular among income-oriented retail investors, are still trading at high enough levels that discount just a garden-variety recession in commercial real estate. REITs were designed to invest in portfolios of rental properties, and generally pay no corporate income taxes if they distribute at least 90% of their profits as dividends to their shareholders.

REITs were designed to thrive in an environment of steadily rising property values and rents. But in this ice age for commercial real estate, the REIT business model will cease to function properly; a REIT’s tax-free status doesn’t allow it to retain much excess capital during lean times. Since REITs pay out all their earnings, they cannot grow without taking on more debt. During the boom, a REIT strategy encompassing growth, leverage, and acquisitions was a virtuous cycle that led to juicy dividends and soaring stocks; in this bust, it’s morphed into a vicious cycle of dividend cuts, dilutive equity offerings, debt offerings at double-digit interest rates, and bankruptcies.

The REITs that levered up and grew too fast at the peak will go to zero in bankruptcy. Others could fall into the low single digits by year-end as the market anticipates that creditors will take title to many properties in 2009 and 2010. These developments would push the value of the REIT Index dramatically lower.

$1.6 Trillion in Commercial Real Estate Debt Needs to Be Refinanced

The REIT sector is undercapitalized – just as the big banks were last year. If you mark the value of commercial real estate to market, it tells you that REIT debt in all its forms – commercial mortgages, unsecured notes, secured lines of credit – is much too burdensome. Equity cushions that seemed adequate at the commercial property market peak are now thin. REITs don’t have to mark their assets to market each quarter like investment banks. But you can be sure that before committing a single penny to a secondary offering of REIT stock, institutional investors will mark property portfolios to market.

Marking property to market will result in many underwater commercial properties. This is critically important because the combination of underwater properties (insolvency) and imminent debt maturities (illiquidity) tends to wipe out equity. The maturities over the next five years are staggering, and these debts were sloppily underwritten near the peak of the credit bubble. According to Goldman Sachs research, roughly $1.6 trillion in commercial real estate debt is coming due 2009-2013.

Lenders will not be willing to refinance mortgages in situations where mortgage debt exceeds the value of the property – so-called “underwater” properties. In order for all of these $1.6 trillion in loans to qualify for refinancing, hundreds of billions in new equity will need to be injected into properties. This much new equity capital dedicated to commercial property ownership will not exist in the investing environment of 2009-2013, so many of these loans will default.

In a scenario of paying off staggering debt loads under stress, the claims of common shareholders are either diluted or wiped out completely. This is the scenario facing General Growth Properties, and shareholders will be lucky to recover anything. You can find shades of the General Growth saga throughout the REIT space.

The Credit Markets Are Signaling Danger for REITs

Bulls argue that REIT stocks are cheap enough to buy. After all, they’ve declined to the point that you’d be buying ownership stakes in commercial real estate at prices well below peak values. Also, the high dividend yields already reflect plenty of pessimism.

What is the credit market’s response to REIT bulls? Creditors will take title to many properties in bankruptcy, and dividends will be paid mostly in new shares of REIT stock, rather than cash. I side with the credit markets.

A review of the aggregate REIT balance sheet – and the delusional commercial real estate purchases during the 2006-2007 peak – will tell you that this won’t be a garden-variety bear market in REITs. Supply of retail, office, hotel, and industrial space will greatly exceed demand for several years. In most cases, tenants will have the upper hand in lease renegotiations. This bear market, which is still in its early stages, will go down as the worst REIT bear market in history.

Will the TALF Bail Out REIT Shareholders?

So will the TALF come to the rescue? Wasn’t the Federal Reserve’s “term asset-backed securities loan facility” (TALF) designed in part to mitigate the systemic damage from the time bombs ticking inside of CMBS? A primary reason for the recent rally in REIT shares is hope that the TALF will help restore value to equity of the most-indebted REITs by loosening up lending for commercial mortgages. The Dow Jones U.S. real estate index rallied from an intraday low of 80 in early March to a recent 130 (see chart below). But this REIT rally is based on hope, rather than strong fundamental evidence.

The Fed does not restore equity value to leveraged financial companies sitting on toxic assets; it merely tries to prevent stressed borrowers from unwinding positions too quickly. Look at how little equity value the Fed’s unprecedented lending facilities salvaged for Citigroup shareholders. TALF will do little to preserve equity value for highly indebted REITs. The Fed did not eat the losses on Lehman Bros.’ garbage securities, nor will the Fed or the Treasury eat losses that must be first absorbed by shareholders of overleveraged REITs.

Plus, potential limits on executive pay could limit interest in TALF participation. Special Inspector General Neil Barofsky said in a recently published report that executives involved with the TALF program “could be subject to the executive compensation restrictions.” Whether or not compensation restrictions are enacted as part of TALF, the mere threat of capricious rule changes and taxes imposed by Congress and the administration will scare many potential managers away from TALF.

While there are certainly opportunities to be had in this market, as I see it, REITs aren’t one of them. That said, after the closing bell today, I’m recommending an exciting new play to my Strategic Short Report readers that could generate as much as $200,000 in profits. If you want to be one of the first to act on this opportunity, visit the Strategic Short Report website for more details.

Regards,
Dan Amoss

July 10, 2009

Beware of the REIT Reality was originally featured in the Penny Sleuth.