CASH IN HAND


Mortgage REIT Madness

Jeffrey R. Kosnett

Yields on real estate investment trusts that hold mortgages are soaring, but the gains may be an illusion.



The yield figures explode off the screen: 18%, 15.7%, 14%, 13.2%, and on and on. They do go all the way to zero, in fact. These are the current dividend yields among the 30 or so real estate investment trusts that hold loans and mortgages or trade mortgage-backed securities instead of actual property. The question is whether it's time to take a shot or if these yields are a temptation to ruin. The answer: Some of each. But first, some background.

In June 2003, I prophesized in this column that shareholders of mortgage REITs would suffer when short-term and long-term interest rates converged. That's because this business, though not identical at every mortgage REIT, is built on borrowing at short-term rates and lending (or investing in mortgage securities) at long-term rates.

When short-term money is much cheaper than long-term credit, which was true until the Federal Reserve Board started raising rates in June 2004, you could profit mightily off the spread. People made great gushers of income and -- because mortgage REITs are structured as REITs for tax reasons -- passed it along, giving off fat dividend increases. Because the Fed wasn't doing much rate-wise, the stock market, which lives in the present, further rewarded the stockholders with sharply higher share prices.

But once the Fed began its rate-hike campaign, the squeeze set in as expected and, in many cases, dividends fell -- or the trusts reached into their capital reserves to keep up the distributions because current earnings didn't cover them.

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Consider the ups and downs at perhaps the best-known mortgage REIT, Annaly Mortgage Management (symbol NLY), which sold for $6 in 1998. Three years ago this month, it traded at $20 and paid 60 cents a quarter in dividends, or $2.40 a year, for a 12% yield. Today, Annaly's a little above $13, but it's not the same stock. Instead of a 60-cent dividend, the last three quarters' payouts have been 13, 10 and 11 cents. The high earnings of just a few years ago swung to a loss in 2005. Annaly still yields 5% on a 12-month trailing basis if you count the three months that ended in March 2005, its last high-paying quarter. But by then, the spread between borrowing and lending was eroding -- and so was Annaly's share price.

The market's opinion now changes almost daily on whether the Fed is finished raising short-term rates. There's also disagreement on whether recent upticks in inflation will send longer-term interest rates much higher. So it's possible this spread could widen again, which would be good for any investment that depends on a widening gap between short and long rates. So it's no shock to see Annaly's stock recovering from a low of $11 around the turn of 2005 into 2006, for a total return of 25% so far in 2006 despite the lower dividends. In May, brokerage firm Friedman Billings Ramsey raised 2006 earnings estimates for Annaly from 71 cents a share to 88 cents. Seven investment firms have upgraded their view of the stock since last winter.

Shares of some of Annaly's cousins also are rallying. Novastar Financial (NFI), the REIT with the 18% yield, fell from $70 at its peak in 2004 to $25 earlier this year and is now at $33. New Century Financial (NEW) which at $49 is priced to yield 15%, is up from a bottom of $30 last fall. It had peaked at $61 in early 2005. There are others like this. The REIT organization's index of mortgage REITs shows a total return so far in 2006 of 11.3%, a bit above the 10.5% on the property REITs that analysts and shareholders often describe as continuing to defy gravity. The early 2006 results are surely a surprise after the mortgage REIT index lost 23% in 2005.

So, ladies and gentlemen, is this rebound sustainable? Should you go out and buy New Century or Novastar and figure that once the Fed stops pumping rates it'll be like 2003 all over again? On a conference call with investors last month, New Century's management all but guaranteed that the company will pay $7.30 of dividends this year. That means even if the stock market decides a 10% yield is generous enough, you would have a $73 stock and a total return of better than 50%.

By that score, it looks like a no-brainer to try. But there are cooler heads out there. One is Larry Goldstone, president of Thornburg Mortgage, a REIT that is hands-down more stable than those named above because it is managed conservatively and mostly makes its own mortgages and keeps them. Goldstone acknowledged that if short-term rates do fall and there's once more a three-percentage-point spread, the habitually more excitable mortgage REITs will fly high. But that also depends on whether there are problems with the creditworthiness of their investments. "I'm not a big fan of the subprime sector," he said, which means making loans to borrowers with weak or impaired credit, or of mortgage REITs that depend on ever-increasing loan volume. Marginal borrowers are starting to default in larger numbers and the volume of home sales may be slowing even if housing prices avoid a big drop.

Goldstone didn't single out any subprime mortgage outfits by name, but it's easy to go to the Web sites of any super-high-yield trust and see where it invests. They'll all claim to be better than the next guy at handling the risks, hedging bets and finding ways to earn these high dividends. But unless the Fed really does stop tightening credit soon and the bond market decides mortgage rates have already risen enough, these surprising gains in early 2006 may end up to be just an illusion. Go for it only with money you can afford to lose.




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