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A License to Print Money?

07/20/2009 1:00 pm EST

Focus: REITS

Bryan Perry

Editor, Cash Machine, Premium Income, Quick Income Trader, Instant Income Trader

Bryan Perry, editor of Cash Machine, says agency REITs should profit for some time from the spread between short- and long-term interest rates.

At present, real estate investment trusts (REITs), that borrow heavily with short-term interest rates of 1% to 2% and purchase mortgage bonds yielding 4% to 6% are able to capture a wide spread of 3% to 5%. These are Agency REITs, and they are enjoying the best of times. That's because Agency REITs that leverage their portfolios five or six to one can generate up to 20% in interest revenue, and since they are structured as a REIT, they are required to pay out 90% of that revenue stream to shareholders to avoid paying corporate income tax.

Agency REITS only trade in 100% government-backed mortgage bonds that are highly liquid, rather than trying to transact physical real estate. As long as mortgage rates don't plummet or short-term interest rates don't spike too fast and close the spread on the long and short end, these REITs will keep printing money at their current rates.

Interest rate spreads are at ten-year highs, and we can now assume the current spread between low short-term rates and rising long-term rates to continue well into 2010, or until the employment picture brightens. So, buying into Agency REITs looks to me like a strong investment theme for the next two to four quarters.

With a market capitalization of $8.2 billion, Annaly Capital Management (NYSE: NLY) is five times larger than its next competitor. It's paying a sweet dividend yield of 15% from an annual payout of $2.40 per share, paid quarterly. The company raised the dividend payout from 50 cents to 60 cents in the latest quarter to reflect the improving metrics for maximizing the short-term versus long-term spread strategy. Shares of NLY should be purchased under $16 with a price target of $20. (It closed just below $16 Friday.

Hatteras Financial (NYSE: HTS), an agency REIT with a market capitalization of just under $1 billion, was founded in 2007 with a listing on the New York Stock Exchange in May 2008 at an initial public offering price of $22 per share. Today, the stock is trading at $27.50 per share. After the financial crisis blew up last year, one would be hard pressed to find a financial-related stock up 25% over its June 2008 level, not including dividends. These guys obviously saw the opportunity and acted on it, big time.

At its current price [below $29,] shares of HTS are sporting a yield of 15.3% and complement the purchase of Annaly beautifully. Shares of HTS should be bought under $29 or better, and I'm looking for the stock to trade up to $32 over the next 12months.

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