The Best Way to Invest in Real Estate

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By Steve Christ

Tuesday, October 11th, 2011

Like most Americans, Jim and Mary Epple cringe every time the phone rings in the middle of dinner. Nine times out of ten, it’s a call from a loan officer looking to lower their 6.25% mortgage rate.

With great credit scores, steady jobs and a spotless payment history, the Epples would be great candidates except for one thing.

They are hopelessly underwater.

That makes getting a new loan impossible for them, which is why they have stopped answering the phone.

Why bother? says Mary. When we tell them our house is worth $150,000 less than what we paid for it, the guy on the other end usually can’t hang up fast enough.

The sad part, Jim adds, is that we could really use the money.

Now that rates have dropped again to generational lows, the Epples’ frustration is beginning to peak. Because with a new loan carrying a 4.25% interest rate, the Epples could save roughly $7,128 a year over their current mortgage.

In five short years, that would make for an extra $35,640 in the bank enough, Jim says, to give their daughter a head start on her college education.

The Flip Side: REITs on the Bargain Rack

Unfortunately, a similar situation plays out every night in millions of homes across America.

According to the latest data, there are 10.9 million homeowners just like the Epples who now owe more than their home is worth. For three out of four of these troubled homeowners, that means being chained to a mortgage that is likely considerably higher than the current market rate.

While that’s certainly bad news for millions of families, there is a flip side. For the holders of these notes, they are nothing but money in the bank.

Here’s why.

When big pools of borrowers (like the Epples) are unable to refinance, the cash flows thrown off by those mortgage bonds are extended, giving them a much longer life cycle.

That’s the other side of the trade and one of the reasons select Mortgage REITs (MREITs) have been able to maintain their unbelievably high cash payouts, with some dividend yields actually reaching as high as 21%.

That’s not a typo. It’s true: Juicy, double-digit yields like those can literally be found everywhere you look in the MREIT space.

The good news for today’s dividend investors is that most of these MREITs have actually fallen below their book value with the latest sell-off. Down on average by more than 15%, that puts these companies on the bargain rack, since many of them now trade below their benchmark liquidation value.

Currently at or very near their book values, MREITs are winning trades for investors focused primarily on the income streams these stocks throw off.

What is an MREIT?

Simply put, an MREIT is a real estate investment trust or REIT that invest in mortgages, usually through mortgage-backed securities.

They typically borrow at low rates and lend in the mortgage markets at higher rates, earning money on the spread between the two.

What’s more, using the leverage provided by the equity, they are then able to boost those returns in today’s environment into those juicy, double-digit yields I mentioned earlier.

The payoff is that as a REIT. each company must agree to pay out at least 90% of its taxable profit in dividends turning these companies into veritable money machines, since they must distribute almost all of their profits to shareholders in order to maintain their special status and avoid corporate taxes.

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The Best Way to Invest in Real Estate

Now, I must admit talking up real estate investments in today’s markets may be something of a hard sell. After all, between falling home prices and mounting foreclosures, investors could be forgiven if they think these investments are on the risky side due to credit risk.

But the truth is that by investing in what’s known as an Agency MREIT, investors actually end up with very little default risk at all. For that, you can thank your Uncle Sam.

Agency MREITs invest virtually all of their assets in securities backed by Government Sponsored Enterprises. Known commonly as GSEs, these Fannie Mae, Freddie Mac, and Ginnie Mae loans actually carry no credit risk at all since they all have the implied backing of the federal government.

That’s one of the big reasons Agency MREITs have been among the few stocks in the financial sector to not only survive but prosper during the ongoing credit crisis. It’s all about the backstop.

That leaves interest rate risk as the biggest downside for these companies; rapidly rising rates and or a flattening of the yield curve would work to depress the returns these companies can earn on the spread.

However, with Ben Bernanke ‘s commitment to keep borrowing costs at rock bottom into 2013, those fears appear to be overdone.

As for the Fed’s Operation Twist, it’s hard to see how the long end of the curve can fall much further from here.

Given the relatively stable environment between rates and prepayments, that makes the risk/reward profile for these stocks attractive when you consider their eye-popping dividends. In fact, the dividend streams are so large these days that these stocks practically hedge themselves!

Companies with the Juiciest Yields

That said, my two favorites in the group are at or very near book value:

1. Annaly Capital Management (NYSE: NLY ): An Agency REIT, NLY currently trades at a 0.97 times book value while paying investors a 15.50% yield. Over the last ten years, Annaly has returned 320% to investors while the broader markets have been stuck in the ditch. Longer term, the results are even more impressive:

2. American Capital Agency Corp. (NYSE: AGNC ): Another topflight Agency REIT, AGNC trades at 1.01 times book while paying investors a 21% yield. A newer entrant to the sector, ANGC has returned 32% annualized to its investors since July 2009:

For yield-hungry investors, those are two companies that are pretty hard to beat.

As for the Epples, it’s shaping up to be another long two years of phone calls.

Your bargain-hunting analyst,