Forget About Being an Owner, Buy These 2 REIT Stocks Instead


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Co-produced with Treading Softly

A big part of the “American Dream” is home ownership. It’s no wonder more than half of Americans own:

Homeownership in the United States

St. Louis FED

There is something powerful and emotionally satisfying about saying a piece of land is yours. This is why people risked their lives to move west in the 18th and 19th centuries, seeking to claim a piece of land.

Economically, real estate is an extremely useful and valuable asset. Residential, commercial, industrial and agricultural all need land. For years, owning or owning multiple properties was seen as directly linked to long-term wealth. Even to this day, we see writers talking about the value of owning real estate:

Forbes is a real estate pro

Forbes

There seems to be a disconnect with the “wealth generating” view of real estate and the amount of work and effort it takes to maintain and maintain properties, think of the many downsides:

  • Repairs and maintenance
  • Dealing with disgruntled tenants
  • Collect the rent
  • pay mortgages
  • pay taxes
  • Evictions if necessary
  • Advertise the property to find tenants

The list could go on further. Many people who get into property rental learn that it’s a lot of work and it comes with risks.

There’s a much better way to get real estate exposure without having to put on your 1900s fat cat hat and cigar and round up some tenants. Modern investors may use real estate investment trusts instead – these companies are designed to buy, hold, sell and lease real estate assets. You can buy shares of it, let management take care of the headaches, and collect your dividends instead.

Even with REITs, there are two main ways to invest in real estate. You can invest in “equity” REITs that buy real estate, find tenants, and collect rents. Or you can invest in “mortgage” REITs that hold mortgages secured by the property. The only thing a lender has to worry about is whether or not the borrower repays the loan. The borrower is responsible for all headaches and expenses at the property level!

For most of us, the easiest way to increase our income streams and build long-term wealth is to invest in REITs. Today we are looking at two mortgage REITs. We can take advantage of the American dream and the desire to own real estate by lending. If the borrower does not pay, he risks foreclosure. They pay and you get paid. It’s that simple.

Let’s dive!

Pick #1: NLY – Yield 11.4%

Annaly Capital (NLY) is an “agency” mortgage REIT, which means that its primary investment is mortgage-backed securities guaranteed by government-sponsored companies. If a borrower defaults, the GSE will redeem that mortgage at face value.

Agency mREITs find themselves in a unique era and are another classic market case following NAV changes, disregarding the big picture. After having had a very strong first half of 2021, agency mREITs lagged in the second half as NAVs fell. The market shunned them. The irony is that this drop in book value was essential for NLY to improve its earnings.

Asked what it would take to increase the dividend in the latest earnings call, CEO Finkelstein said: (emphasis added)

In terms of what we want to look for, to increase yields or increase dividend, we would need to see, obviously wider asset spreads and a better investment opportunity, more sustainable income.

We are happy with the earnings situation this quarter, and we are happy to cover the dividend until 2022, certainly. But we recognize that we have consistently earned the dividend since the second quarter of 2021.

To increase the dividend, NLY management wants to see “wider asset spreads”. What does that mean in English? This means that NLY wants to be able to invest at higher returns. Higher returns occur when MBS prices to come down. When MBS prices go down, the value of MBS already held goes down. That means NLY’s book value has to go down so they can raise the dividend!

The main problem in 2021 was that the Fed was buying up all the MBS.

Presentation NLY Q3

Presentation NLY Q3

In 2020 and 2021, the Fed bought almost all of the MBS and the Fed bought “blindly” regardless of the market price. As a result, MBS prices were artificially high throughout the year. NLY’s response to these conditions has been to remain patient. Management acknowledged that eventually the Fed would stop buying as much and prices would eventually come down.

Knowing that a price drop was coming, NLY dropped its leverage to 5.2x debt/equity. This compared to 7.2x debt to equity before COVID. This ensures that when prices fall, NLY would be able to take advantage of leverage and invest at lower prices (higher returns) and make the most of them, unlike some other mREITs which have maintained debt levels above 8x and will be unable to buy more.

NLY was right, MBS prices had to come down. Prices fell throughout the second half of 2021 and fell sharply in the first week of 2022.

MBS and Treasury awards

MBS and Treasury awards

This is the buying opportunity that NLY has been patiently waiting for!

Some investors like to chase book value and panic when it drops 5%. We focus on cash flow. We can get an 11.4% return investing in NLY today, and conditions have improved to the point that NLY can finally look to take advantage of the turbocharging of its earnings. Excess earnings will quickly rebuild book value and also provide management with the opportunity to significantly increase the dividend.

Choice #2: ACRE – Yield 9.7%

Ares Commercial Real Estate Corporation (ACRE) is a “Commercial MREIT”, meaning they invest in mortgages secured by commercial real estate. It is managed by Ares Management (ARES) the same manager as one of our favorite BDCs, Ares Capital (ARCC).

Here is an overview of the characteristics of the mortgages in which ACRE currently invests:

ACRE Q3 Investor Presentation

ACRE Q3 Investor Presentation

There are a few things that jump out at us. First, the portfolio is almost entirely made up of Senior Loans. This means that ACRE has the first lien on the property and is the first to be paid. It’s a great place to be!

Second, 98% of ACRE’s loans are variable rate. With short-term rates close to zero, floating rates can only go in two directions. They can stay the same or increase. This is the kind of investment that we want to have a flexible rate approach. If the rates remain the same, we are very satisfied with the current performance. If the Fed lifts as much as the market currently expects, ACRE will make more money. Heads, we win, tails, we win more!

Third, ACRE has a short average life on its mortgages at just 1.4 years. Commercial mortgages are often much longer, so it is a rather short term. The reason for this is the types of loans that ACRE focuses on, which are primarily “value added” loans or bridge loans. These are mortgages that a borrower takes out when he intends to add to a property. Since the borrower believes their investment will increase the value of the property, they don’t want to end up with a long-term mortgage. They want a long-term mortgage once the value is added so they can borrow more. They will also do a lot of mortgages for large buyers who are looking for capital to complete a new acquisition immediately, with the intention of taking out permanent unsecured financing later.

This short duration means that ACRE is somewhat sensitive to real estate transaction volumes. They rely on new business to fill the pipeline and ensure that they add new mortgages as quickly or faster than old ones are paid off. In 2021, ACRE was on track for $1 billion in new builds and with the real estate market remaining active, they should have plenty of opportunities in 2022.

ACRE has always covered its dividend, with distributable profits covering its dividend by more than 110% in the first 3 quarters of 2021.

ACRE Q3 Investor Presentation

ACRE Q3 Investor Presentation

ACRE is offering an excellent covered dividend today, with prospects for future dividend growth either by expanding its portfolio as they did in 2021, and/or by raising rates.

When it comes to ensuring our income is protected from inflation and the Fed, ACRE is a choice we want in our portfolio!

Shutterstock

Shutterstock

Conclusion

By using NLY and ACRE, we can gain exposure to real estate while benefiting from rate changes. The cash flow from these businesses is immense and we will be rewarded with returns well over 9%! The best part is that there’s no need to sue tenants who try to collect late rent!

So it’s time to put out your cigar, take off the top hat, and pull out the pillow you’ve stuffed under your shirt. We don’t have to deal with the headaches of being an owner, we don’t even have to call ourselves owners and pretend to be one!

Instead, we can just be us income investors and retirees who have a large stream of income from various types of assets and sources. Owning the debt related to real estate and receiving generous levels of income from these types of assets, both residential and commercial, is well worth it.

Ultimately, we’re looking to fund our retirement, set up multi-generational portfolios for income, and maybe even allow our children’s children to enjoy the fruits of our labor. Owning income-producing securities is an essential way to achieve these dreams.

All it takes is one step at a time, this can be your first step.

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