Understand the Good vs. Bad Mortgage REITs

Dividend Investing, Growth Stocks, Real Estate Investment Trusts (REITs)

Over the past weekend I was an invited speaker at the Seattle MoneyShow. One of my presentations was a Master Class titled, “Not All Dividend Investments are Created Equal!” In the two-hour discussion I covered all of the different types of exchange traded income investments, including real estate investment trusts (REITs).

REITs fall into one of two distinct categories. Equity REITs own commercial properties, including apartments, hotels, offices, industrial properties, and even prisons. Finance REITs operate on the lending side of real estate, either by making residential or commercial mortgages or owning a portfolio of mortgage backed securities. Finance REITs can also be separated into two camps, based on their business strategies. Those differences can make a difference for investors in their high yield stock portfolios.

The finance REIT discussion during my class was a livelier part of the whole class. A lot of income investors own these stocks, and the class participants were surprised to learn which finance REITs were good to own and which ones are dangerous to their wealth.

In both size of companies and number of stocks, the finance REIT sector is dominated by companies that invest in residential mortgage products. The most common business model in this group is to own portfolios of residential mortgage backed securities (MBS). These MBS are investments in pools of mortgages guaranteed by the federal agencies of Fannie Mae, Freddie Mac, and Ginnie Mae.

These high yield stocks sound safe because of the implied federal government backing of the mortgages in their portfolios. The problem comes with the steps these companies must take to turn 3% agency MBS yields into 10% plus REIT yields. The yield step-up requires leveraging a REIT’s equity 5 to 8 times.

The whole business model is to own longer duration MBS acquired with short term financing. They can hedge some of the interest rate risk, but an inverted yield curve would turn net interest income into big losses for this group of REITs. I am not going to name names today. I have found that investors understand the dangers of these stocks. I had one class attendee tell me that he would be selling his investment in an agency MBS REIT and buy another stock we had discussed.

The stocks to own in the REIT finance sector are the commercial mortgage lenders. Commercial mortgages are very different from residential mortgages. This type of mortgage is written with higher interest rates, adjustable rates, with shorter terms. As a result, commercial mortgage REITs use a lot less leverage, and have borrowing rates match with lending rates. With this business model, higher interest rates will produce greater profits.

Another difference is that most of the commercial mortgage REITs are actual lenders instead of managers of portfolios of MBS. This side of the finance REIT world can be counted on to be able to sustain dividends and grow those dividends as interest rates move higher.

Here are three commercial mortgage REITs to consider.

Blackstone Mortgage Trust, Inc. (BXMT) is a pure commercial mortgage lender. The REIT receives high quality mortgage lending leads from its sponsor, The Blackstone Group L.P. (BX).

As of its 2019 first quarter earnings, BXMT had a $16.1 billion portfolio of senior mortgage loans. The loan portfolio grew by $4 billion over the last year. 94% of the portfolio is floating rate. The loans were at 62% loan to the value of the underlying properties.

In the first quarter the company originated $699 of new loans and funded $204 million of previously originated loans. Leverage is 2.8 times debt to equity.

The stock currently yields 6.8%.

Ladder Capital Corp (LADR) uses a three-prong approach to its investment portfolio. The three legs are commercial mortgage loans, with a current $3.5 billion portfolio of floating and fixed rate loans; commercial real estate equity investments, valued at $1.2 billion; and commercial MBS bonds, worth $1.6 billion.

The business plan is that the three groups are more or less attractive through the commercial real estate cycle. Leverage is a comfortable 2.6 times.

Since it paid its first dividend for Q1 2015, Ladder has steadily increased the quarterly payout at an average 8% annual growth rate.

The shares currently yield 8.3%.

Starwood Property Trust, Inc. (STWD) is one of the largest commercial lenders of any business type – including banks. The company currently has a $8.2 billion loan portfolio with a 64% loan to value.

Since launching in 2009 the company has deployed over $40 billion in loans and investments with zero realized losses. In recent years, Starwood has acquired the largest commercial mortgage special servicer. This acquisition has led to growth in CMBS origination and investments.

The company also owns a $2.7 billion equity commercial property portfolio that generates 9% to 12% cash on cash returns. Recently Starwood has invested in non-agency residential MBS. The $860 million RMBS portfolio has a 63% loan to value.

Management constantly looks for investment opportunities both in and out of the commercial mortgage business.

STWD current yields 8.4%.

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