Mortgage real estate investment trusts (M-REITs) hold portfolios of mortgage-backed securities; whereas property-owning REITs seek to maximize rents and occupancy rates, an M-REIT’s performance hinges on management’s ability to prepare for credit and interest rate risk, explains income expert Roger Conrad, editor of Capitalist Times.
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.
To pump up yields, M-REITs often use leverage. These factors explain why the M-REITs we follow sport an average yield of more than 10% at a time when interest rates on even the longest-term mortgages are less than half this amount.
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.
Only one of these M-REITs earns our buy rating: MFA Financial (MFA). Management has sought to control interest rate risk, reducing the net duration of mortgage-backed securities in its portfolio to 0.56 years.
Adjustable-rate mortgages, hybrid loans, and step-up securities with built-in increases account for about 75% of MFA Financial’s holdings.
The trust continues to grow its securities portfolio, with its total holdings exceeding $2 billion. The recovery in the US housing market has helped to reduce the average loan-to-value ratio in its underlying holdings to 76% at the end of 2014; a far cry from the 105% registered in 2012.
Meanwhile, the proportion of underwater loans declined to about 12%, allowing the M-REIT to reduce its reserves against future losses. These encouraging trends should continue in 2015.
MFA Financial’s future prospects depend on management’s ability to control risk while replacing maturing loans and growing the underlying portfolio, challenges that also apply to the rest of the M-REIT universe.
However, relative to its peers, MFA Financial boasts a track record of stability and was one of the few M-REITs to avoid cutting its dividend in 2008, an impressive feat at a time when many of its rivals imploded.
MFA Financial’s high-quality portfolio is structured to provide a modicum of protection against credit and interest rate risk; investors can count on a current return of 8% to 9% annually from dividends.
Trading at 96% of book value and yielding 10.1%, MFA Financial has been added to our Lifelong Income Portfolio.
Prospective investors should note that MFA Financial pays a variable dividend that fluctuates with the trust’s profitability and is therefore best-suited for aggressive investors.
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