The dividend yields are fantastic. Real estate investment trusts specializing in mortgages are yielding between 9 and 15 percent.
That can look awfully tempting when bank savings accounts yield only 1 percent or so, and a five-year Treasury note will get you only 1.7 percent.
So what's the catch? Here it is: Mortgage REITs can take you on a wild ride. Over the past five years, they've lost as much as 42 percent (in 2007) and gained as much as 25 percent (in 2009), according to total-return figures from the National Association of REITs.
This isn't an investment for nervous Nellies. Either rising interest rates or a double-dip recession could knock the wind out of mortgage REIT prices. But, if you don't think either of those things are about to happen, then mortgage REITs start looking sweet.
First, a lesson on REIT mechanics. Mortgage REITs buy mortgages, mortgage bonds, collateralized mortgage obligations and the like. That gets us to the first risk involved in mortgage REITs — credit risk.
A tidal wave of homeowner defaults crashed the mortgage bond market in 2007 and 2008, bringing on the Great Recession. A second dip into recession could bring another wave of defaults, crashing mortgage REIT stocks again.
Most REITs borrow on the short-term debt markets to finance their mortgage purchases. They make their money on the spread between low short-term interest rates and the higher rates they collect on their mortgages. That creates rate risk.
All that borrowing boosts profits, but it also leaves REITs doubly vulnerable if rates rise. Rising rates can raise their cost of financing, while lowering the value of their mortgage holdings, creating a profit squeeze.
Is any of that likely to happen? Not soon, according to most economists. The statistical tea leaves lately have been indicating slow-to-moderate growth with little inflation. The Federal Reserve, for instance, is forecasting growth of 3 to 3.5 percent this year, down slightly from its previous estimate, and 3.5 to 4.5 percent next year.
Slow growth means the Fed won't feel the need to raise interest rates, possibly until well into next year. If the soothsayers are correct, mortgage REIT investors might hope for smooth sailing for several months.
The situation is still too hairy for some. REIT analyst John Sheehan at Edward Jones says his firm refuses to recommend mortgage REITs. The firm's clients are looking for relatively safe and stable investments, and mortgage REITs aren't either.
"We've seen their dividends being reduced as often as they're increased," he said.
Over the long haul, mortgage REITs do worse than REITs that actually buy real estate, he says. Over the past decade, mortgage REITs averaged 8.8 percent returns compared to 9.9 percent for property REITs.
At Stifel Nicolaus & Co., analyst Michael Widner has a rosier view. He recommends investing in REITs that buy mortgages guaranteed by federally controlled agencies, such as Fannie Mae and Freddie Mac. That eliminates credit risk.
He likes Annaly Capital Management (ticker symbol NLY), which is yielding 15 percent.
"It's a nice place to get a good, solid yield," says Widner. He also likes Cypress Sharpridge Investments, (CYS) yielding 18.5 percent.
Stifel has done investment banking work for Annaly and says it hopes to do work for Cypress.
REITs must pay out 90 percent of their earnings to shareholders, hence the sky-high yields. REIT dividends are taxed as ordinary income and don't qualify for the low 15 percent dividend tax rate.
Performance numbers for a sample of larger companies
| One-Year | Dividend | ||
| Company | Ticker | Return | Yield |
| Cypress Sharpridge | CYS | 22.80% | 19% |
| Annaly Capital | NLY | 26.80% | 15.50% |
| Redwood Trust | RWT | 2.50% | 7% |
| Invesco Mortgage | IVR | 17.10% | 14.60% |
| Capstead Mortgage | CMO | 6.70% | 11.90% |
| American Capital Agency | AGNC | 43.10% | 20.40% |
SOURCE: Bloomberg
