U.S. mortgage REITs

Some readers have asked about U.S. mortgage REITs, or mREITs as they are commonly called. Why have they not caught on with Canadian investors, especially since many are offering double-digit yields? The answer is twofold. First, after the sub-prime debacle many people are highly suspicious of any investment based on American mortgages. Second, the risks are on the high side – but then, so are the returns,

These are not REITs as we understand them in Canada. They do not own shopping centres, office buildings, nursing homes, hotels, or industrial properties. Rather, they invest in portfolios of mortgage-backed securities (MBS) which they leverage by borrowing heavily to increase the asset base. The strategy is to take advantage low short-term rates to amass a huge portfolio of higher-yielding longer-term mortgages. The spread between the borrowing cost and the return on the portfolio represents the profit. For a simplified example, if an mREIT borrows at 2.5 pe cent to acquire a portfolio that yields 4 per cent, the spread is 1.5 percentage points, or 150 basis points.

As we know from investing 101, leveraging can significantly improve returns if the value of the portfolio increases. Conversely, it will magnify losses when things go bad.

The big attraction of mREITs is the eye-popping yields they offer, some of which are in mid-double digit territory. For example, American Capital Agency Corp. (NDQ: AGNC) is one of the oldest and largest of the mREITs with $101 billion under management. The stock closed on Aug. 31 at $34.84 (all figures in U.S. currency). So far in 2012, quarterly dividends have been paid at a rate of $1.25 per share, or $5 annually. If payments were to continue at that level for the next 12 months, the yield based on the current price would be 14.35 per cent. That’s mouth-wateringly tempting for yield-hungry investors.

What could go wrong? The main risk is a rise in borrowing rates, especially a sudden one. Going back to my illustration, if the interest rate on short-term money moved from 2.5 per cent to 3 per cent, the spread would drop to 100 basis points, a decline of one-third. That would dramatically affect the mREIT’s profitability and would probably result in a dividend cut which in turn might prompt a sell-off in the shares. That doesn’t always happen, however; AGNC cut its quarterly dividend from $1.40 to $1.25 at the start of 2012 but the share price continued to trend higher. The yield fell but was still high enough to attract investors.

At the moment, the outlook for U.S. interest rates is benign with the U.S. Federal Reserve Board on hold until at least late 2014. This is the kind of environment in which mREITs thrive, which is why they are so popular among U.S. income investors. But eventually rates will rise and when they do we are likely to see both dividend cuts and capital losses in the mREITs. If you want to avoid that, you’ll need to be nimble when the time comes.

Another consideration for Canadians is the tax implication of investing in mREITs. In most cases, the payments are classified as dividends for purposes of the Canada-U.S. Tax Treaty. This means they will be subject to a 15 per cent withholding tax if the shares are held in a non-registered account or a TFSA. In the case of non-registered accounts, you can claim a foreign tax credit for the withholding tax when you file your return. That does not apply for TFSAs.

Dividends paid on shares held in RRSPs, RRIFs, and similar plans are exempt from withholding tax. However, you are adding risk to your retirement plan if you invest in mREITs at this point.

Since these are U.S. corporations, the payments are not eligible for the dividend tax credit. Also, capital gains distributions in a non-registered account are not eligible for the 50% inclusion rate and will be fully taxed. Any capital gain on disposition is treated in the normal way.

To sum up, mREITs offer excellent cash flow — much more than you will get from any Canadian REIT. The downside is more tax exposure in non-registered accounts and TFSAs, currency risk, and a high degree of interest rate risk. People who are concerned about capital preservation should think carefully about the risk factors before investing.

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