They offer yields so lofty they're likely to fall. But mREITs may still have potential for investors.
By Jon Birger, contributor
FORTUNE -- As bond, CD, and money market interest rates remain mired at rock-bottom levels, investors continue their quest for dividends. One category offers eye-popping yields: mortgage real estate investment trusts, or mREITs (which are required to pass most of their income to shareholders via dividends). Chimera Investment and American Capital Agency each yield more than 19%. And the largest mREIT, Annaly Capital Management -- which we've recommended before -- offers a 15% payout. Are these returns too good to be true?
As their name implies, mREITs invest in mortgages rather than, say, office buildings, and they do so mostly with borrowed money. (Annaly, for example, has a debt-to-equity ratio of 6 to 1.) Like banks, mREITs make their money off the difference between their borrowing costs and the yield on their portfolio. Unlike banks in recent years, they've performed well: The Dow Jones U.S. Mortgage REITs index has a three-year average annual return of 19%.
Some mREITs, like Crexus Investment (CXS), invest in non-guaranteed commercial mortgages bundled into mortgage-backed securities (MBS). Others, such as Chimera (CIM), invest primarily in residential MBS. But the majority -- and the ones we like best -- invest in MBS guaranteed by the federal government through Fannie Mae, Freddie Mac, and other agencies. That means companies such as Annaly, American Capital (AGNC), and Hatteras (HTS) avoid the risk of defaults.
So should you fear mREITS? After all, double-digit dividend yields can signal danger: A yield may rise because the share price is falling and trouble looms. In July 2008, for instance, Fannie Mae and General Motors (GM) both had yields above 10%.
With mREITs, today's unusually high yields do reflect the view that their dividends will slip. Says Gary Kain, chief investment officer of American Capital: "The market is pricing in the fact that long-run dividends probably will be lower."
The question is how much lower. mREITs make their biggest profits when long-term interest rates are high relative to short-term rates, as is the case today. Analysts expect that "spread" to narrow as a new version of the federal Home Affordable Refinance Program -- HARP 2.0 -- lowers mortgage rates and makes it easier for homeowners to refinance out of high-rate mortgages. That will reduce the value of some of the mREITs' existing investments and lower their returns. "New money is going to be put to work at lesser spreads, so it's entirely possible that there will be a dividend cut," says James Kieffer, who owns 6.3 million Annaly shares in the Artisan Mid Cap Value Fund (ARTQX). "But even if the yield were to fall to 10%, that's still an attractive yield in any market." And 10%, it turns out, is Annaly's average yield over the past decade.
This article is from the January 16, 2012 issue of Fortune.
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