Buyer Beware These High-Yield Stocks

If you look at the historical returns for mortgage REITs over the past several years--17.5% five-year compound annual total return for the FTSE NAREIT Mortgage REIT Index as of Nov. 30, 2006--you'd think that these investments can't miss. However, at Morningstar, we believe mortgage REITs bear significant risk, and we'd advise all potential investors to dig deep before taking the plunge.

What Exactly Is a Mortgage REIT?
Generally speaking, a REIT is a company that invests in income-producing real estate assets--at least 75% of total assets--and distributes a minimum of 90% of its income as dividends. In fact, many REITs distribute 100% of income to avoid corporate taxes. Despite not being taxed at the corporate level, the majority of the dividend paid to shareholders is taxed as ordinary income, which is higher than the normal rate for dividend income. To understand the tax consequences of investing in REITs, we would suggest contacting your tax advisor.

More specifically, mortgage REITs represent a special segment of the REIT universe, owning little or no operating real estate. Instead, their assets are almost entirely real estate debt investments. Mortgage REITs profit on the spread between the rate at which they can borrow money and the interest rate at which they can lend the money to others. By borrowing against their portfolios, mortgage REITs purchase additional assets, increasing returns and risks to shareholders.

Mortgage REITs at a Glance
	Moat	Risk Rating	Type of Risk	Price ($)	Fair Val ($)	Dividend Yield ( % )
Redwood Trust (RWT)	None	Above avg	Credit	61.48	47	4.61
iStar Financial	None	Avg	Credit	49.28	30	6.24
Gramercy Capital	None	Above avg	Credit	30.94	24	6.73
Annaly Capital (NLY)	None	Above avg	Int rate	13.81	14	4.15
Deerfield Triarc	None	Above avg	Int rate	16.63	14	9.30
Newcastle (NCT)	None	Above avg	Credit	32.35	30	8.09
Data as of 01-16-07

We view an investment in a mortgage REIT as analogous to investing in a mutual fund or hedge fund: Each represents an investment in a pool of financial securities. When we evaluate mortgage REITs, we scrutinize the experience and track record of managers, analyze their investment strategy, and look at risks to shareholder returns.

However, one important difference to note between mortgage REITs and mutual funds or hedge funds is the price at which they can raise new equity. Unlike mutual funds or hedge funds, mortgage REITs can often raise new equity at a premium to book value, which increases book value per share of existing shareholders and fuels per share dividend growth, as the REIT deploys new capital.

Advantages of Mortgage REITs
Investors find mortgage REITs glamorous for two primary reasons--their high dividend yields and low correlation to other stocks. Since mortgage REITs pay out close to 100% of their net income to avoid corporate tax, their dividend yields can exceed 8%, which is attractive to investors seeking current income. Furthermore, by periodically issuing new equity at a premium to book value, they are positioned for future dividend growth.

Beyond the income stream, mortgage REITs provide diversification to an equity portfolio. According to a study by Ibbotson Associates prepared for the National Association of Real Estate Investment Trusts, REITs are minimally correlated with other types of stocks. Although this study did not specifically examine mortgage REITs, other studies have concluded that the return characteristics of mortgage REITs make them substitutable investments with other REITs. Therefore, one may conclude that the low correlation extends to mortgage REITs, and that the inclusion of mortgage REITs in a diversified portfolio may actually increase portfolio return while reducing overall risk.

So What's the Problem?
At this point, you are probably wondering what Morningstar has against these stocks. Despite the short operating history of many mortgage REITs, this industry dates back several decades. In the late 1990s, mortgage REITs as a group came under significant pressure, and we believe similar issues are popping up again. In 1997, mortgage REITs were on top of the world. The economy was experiencing one of the longest expansion periods to date, interest rates were at low levels, and loan quality was exceptionally strong; however, the prosperous environment rapidly deteriorated. Industry participants blamed the resulting missteps on macroeconomic factors--the Asian economic crisis and the Russian bond default--but the issues went much deeper, and few could avoid the waves created by this quake.

For mortgage REITs that placed a bet on interest rates, problems arose when the yield curve flattened and prepayments subsequently increased. At one mortgage REIT--Capstead Mortgage--pressure resulted when a decline in long-term mortgage rates coincided with an increase in short-term rates, resulting in an income squeeze. The problem was so severe Capstead was even forced to eliminate its dividend in order to protect shareholders' equity.

Unfortunately, the problems did not stop there. The slowing economy and the number of overextended borrowers precipitated a flood of defaults, despite claims of "superior due diligence" processes by many REITs. For example, Criimi Mae was an active participant in non-investment-grade commercial mortgage-backed securities. As described by professor Kerry Vandell in "The Mortgage REITs: Dynamos or Duds," Criimi Mae felt it could withstand the heat but was forced to enter bankruptcy after Merrill Lynch required additional funds to account for the declining value of Criimi Mae's assets.

That said, the storm cloud that hung over the mortgage REIT industry was not reminiscent of Noah's flood. Most of these companies survived the downward spiral of the 1990s and still exist in one form or another today. However, the amount of shareholder value destroyed as a result of this overconfidence and shortsightedness is mind boggling, in our opinion.

Don't We Ever Learn?
Unfortunately, history has a way of repeating itself, and we fear that many of the risks that were present in the 1990s still exist today. We appreciate the fact that it is impossible to generate a sustainable return without taking on risk, but we caution that investors may get more risk than they bargained for in the current environment.

Interest rate risk continues to be a big stumbling block at several mortgages REITs that use short-term repurchase agreements to fund longer-term investment securities, a play that has paid off handsomely when interest rates decline. However, when interest rates increase and the yield curve is flat, companies face big problems. As several financial institutions will attest to, they are already feeling the pressure with regard to interest rates, as the yield curve has been flat for some time. In fact,  Annaly Capital (NLY)--a residential mortgage REIT--has been forced to cut its dividend several times over the past few years, from $0.50 per share in the fourth quarter of 2004 to $0.14 per share in the third quarter of 2006, because of the earnings pressure it has felt from a rising cost of funds.

But even if a mortgage REIT successfully minimizes interest rate risk through a match-funding strategy--where assets are paired with liabilities that possess similar maturities and interest-rate types--it may not be out of the woods just yet. Credit risk could be lurking around the nearest corner. No one can deny that the current credit environment has been pristine; however, we believe this is creating a false sense of security among mortgage REITs, particularly young REITs, whose skills have yet to be tested. In our opinion, these firms have been riding the wave of a favorable real estate environment and will get a wakeup call sooner rather than later. For example,  Gramercy Capital , a commercial mortgage REIT, has yet to record a credit loss--not overly surprising given that the firm went public in August 2004. We'd caution that the firm is heavily exposed to lower-grade investments, and we do not expect this mortgage REIT to continue batting a thousand. We believe subprime mortgage lenders are already feeling the heat from tightening credit, and it's likely that this weakness will flow into other areas of the market.

The final nail in the coffin for mortgage REITs would be their inability to access capital if they succumb to the pressures discussed above. Because REITs are required to pay out 90% of annual earnings to shareholders, these companies are continuously knocking on the door of the capital markets to fund growth, through both equity issuances and new borrowings. However, if the door were to slam shut at the first sign of trouble, mortgage REITs would likely feel a pain similar to the late 1990s.

We don't deny that money can be made by investing in mortgage REITs. However, as indicated by the above-average risk rating we place on the majority of the mortgage REITs in our coverage list, we'd require a significant margin of safety to our fair value before we would consider investing.

Ryan Lentell contributed to this article.