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Assessing The Risks Of Mortgage REITs

Posted: Oct 29, 2008 08:07 AM by Gregory S. Davis

Tickers in this Article: CMO, BCS, STT, MFA, GS, NLY, REM

The great utility of taxes for a government is the stream of income generated regardless of market conditions. For individual investors who do not have the power to levy taxes, one alternative for establishing their own stream of income is to exercise their right to choose investments that offer dividends. The iShares FTSE NAREIT Mortgage REIT Index Fund (PSE:REM) may turn investors away at first glance, but its healthy 17.64% dividend should give investors enough reason to pause. To begin with the basics of REIT investments, read What Are REITs?)

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Reasons to Stay Away
The iShares FTSE NAREIT Mortgage REIT Index Fund invests primarily in REITs that lend money to developers and in residential and commercial mortgages. The fund just launched in May of last year. Early investors have shared the painful experience of losing more than 50% of their investment value since the beginning of the year. Foreclosures and sub-prime mortgages have led to huge debt write-downs and bank failures that have been a major component of the current financial shock. According to RealtyTrac, a real estate foreclosure property listing service, foreclosures increased 21% for the 12 months ending in September.

Why Throw Good Money After Bad?
Mortgage REIT Annaly Capital Management (NYSE:NLY) represents more than 25% of REM's portfolio. Annaly's list of top institutional holders includes financial institutions that have managed to avoid the subprime-related debt losses including Goldman Sachs (NYSE:GS), Barclays (NYSE:BCS) and State Street (NYSE:STT). Although Annaly's focus on investing in debt securities should make investors cringe, the stock's 18.60% dividend has offered a measure of protection against the falling market. If larger institutions are still willing to hold shares of a mortgage REIT company like Annaly, there's a possibility that the dividend payout makes the REIT worth holding on to until the investment comes back into favor. Other top holdings for REM with high dividend payouts include MFA Mortgage Investments (NYSE:MFA) at 18.50% and Capstead Mortgage (NYSE:CMO) at 25.30%.

A Note of Caution
The very low volume suggests the REM fund may be difficult to get out of once an investment is made. Investors should also note that it's not certain when confidence will return to credit markets or how new regulations may change how mortgage REITs can profit for debt securities.

Final Thoughts
Dividend payments are not a guarantee and they are definitely not as reliable as taxes for securing a stream of income. The dividends offered by REM do offer investors a downside cushion and a play on the eventual recovery of mortgage securities. While now may not be the best time to consider REM as an investment, its worthwhile to keep out-of-favor investments in mind for the future.

For further reading, see The REIT Way and Basic Valuation Of A Real Estate Investment Trust.

By Gregory S. Davis

Gregory S. Davis is the owner of G. Davis Capital, a Registered Investment Advisor with the state of North Carolina dedicated to providing independent investment research and education. His core methodology for choosing investments includes going against emotion eliciting headlines while focusing on asset diversification. G. Davis Capital also publishes the ETF education website, ETFReady.com . Gregory is a graduate of the Wharton School of Business and he has received an MBA from Bowie State University.

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