It’s been a long time since real estate investment trusts have garnered much interest, but that tide is changing, writes Jim Trippon of Dividend Genius.

Many dividend investors look at mortgage REITs in one of two ways:

  • The mREITs are usually high-yielders, so they provide an opportunity for terrific income.
  • They are considered high risk, so many investors simply shy away.

If you look closely at the sector, however, the reality of the mortgage REITs is not necessarily as extreme as some investors think.

Part of the problem of looking at the mREITs is that we’ve always been conditioned to simply think that high yield automatically confers high risk. While this is generally true, that’s maybe too quick an assumption.

If you’re using a stock screener—and you should always ultimately rely on your own informed judgment, not just data—your screener may select something that has a 20% yield but the screener says nothing about its risk. And while a stock paying a 20% yield almost certainly has some sort of problem, particularly given the today’s low-yield climate, it’s not quite accurate to put the mREITs, many of which yield from 10% to 15%, in that automatic throwaway bin of excessive risk.

There is no doubt that mortgage REITs are riskier than the big blue chips, which pay 2% or 3% and have completely different business models. This is inherent in the mREIT business.

There is interest-rate risk and credit risk built into the mortgage REIT business, so those are considerations. But the intriguing aspect of these investments is that their business models are also set up to perform well in the low-interest-rate environment we’re now in, and some of the risks are dampened.

MREITs invest in mortgage-backed securities that yield a certain amount. The mREITs use leverage to fund these investments. The difference between what their mortgage investments yield and the cost of the debt is the interest-rate spread, or margin, and this difference is how the mREITs make money.

The macroeconomics of borrowing at extremely low rates and, yes, leveraging these borrowings to purchase mortgage-backed securities, or MBS, is still in a favorable operating climate. The mortgage securities are agency-backed, meaning government-sponsored enterprises (GSEs) stand behind these securities. So the credit risk should be mitigated for the assets.

Current Climate Changing?
The two main risks, interest-rate risk and credit risk, are ideally managed by the mortgage REITs, but they’re not eliminated. In the last year or so, we’ve read of the supposed imminent demise of the mREITs in this investment cycle.

As for the dividends, the payouts tend to rise and fall, something not unexpected given the high yields. Many of the leading names have recently lowered their dividend payouts, as they have responded to a tighter credit market and what was thought to be the risk of rising interest rates.

The Fed’s announcement months ago of having a bias toward keeping rates low has done little to reassure some investors, who’ve sold out of the group. With dividends lowered—anathema to income investors—and worries about the group, what would be the appeal?

Jeffrey Gundlach of DoubleLine Capital expects further dividend cuts in the group and would avoid the mREITs. He told Bloomberg in December he’d sold all his holdings in the sector. Merrill Ross, an analyst at Wunderlich, on the other hand, has the view that the group is undervalued.

The mREITs trade at a discount to book, and still have attractive spreads. Two of the leading names in the group, Capstead Mortgage (CMO) and Annaly Capital (NLY), are instructive.

Annaly, regarded by many as the best in breed of the mREITs, recently lowered its dividend, as did Capstead. The yield, however, still remains 14.2% for Annaly and 13.7% for Capstead. Annaly has averaged a dividend yield of nearly 13% over the last five years.

That the dividends were lowered doesn’t automatically confer a trend of falling payouts by the mREITs. If interest rates spike up, then a seismic event could certainly happen in the mREIT sector…although historically, gradual rises off the bottom of interest rates have seen the group still perform respectably.

Annaly had a recent insider buy of $850,000 worth of shares, according to a recent Forbes piece. So there is action from the undervalued camp.

Annaly has earned over $1 billion in each of the last two years, with $1.9 billion in 2009 and $1.3 billion in 2010. Michael Farrell and his management team are regarded as among the most accomplished in the field, so the advent of the dividend cut is seen as by some as a part of the realization of a deleveraging strategy to get in front of the interest rate direction.

The company is expected to report EPS of $2.41 per share this year and $2.29 in 2012. Revenue is expected to climb from this year’s $2.4 billion to nearly $2.6 billion next year.

Annaly has a ROE of nearly 9%, and prior to its dividend cutback had raised its dividend a total of 40% in the last three years. Mortgage REITs aren’t for everyone, but they might fit even that small speculative part of even a dividend portfolio for some.

Subscribe to Dividend Genius here…

Related Reading: