Thursday, October 27, 2011

Mortgage REITs: too hot to touch?

By Erwan Quintin, Assistant Professor of Real Estate at the Wisconsin School of Business

At a time where a wall of cash is sitting on the sidelines looking for yield, mortgage REITs have garnered a lot of attention. The recipe is simple: 1) borrow short term at rates currently near 0% and invest in mortgages or mortgage-backed securities, 2) lever highly, and voila, dividend yields close to or in excess of 20%.

The catch behind these lofty yields, of course and as always, is risk. Minor changes in the spread between mortgage rates and short rates can cause yields and market valuations to fluctuate wildly. The past few weeks are evidence of that, as the Motley Fool explains here.

At this juncture, a mortgage REIT play is a bet that the yield curve will continue to slope sufficiently up for sufficiently long. The Fed has promised to keep the short-end down until 2013 but, at the same time, has announced its intentions to bring the long-end down. Its ability to deliver on both objectives will define mortgage REIT returns over the next few quarters. As the Motley Fool writes, REITs can take steps to mitigate their exposure to yield curve inflections, choose their preferred location on the yield/risk menu, and in the process target investors with different tolerances for risk.

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