Fed May Make This Asset Class Attractive to Investors

Real Estate Investment Trusts (REITs) have gotten a bad rap despite double-digit dividend yields, partly because the companies have suffered a loss in share price thanks to growing uncertainty in the flow of credit and the future of the American economy. Some of the most volatile REITs trade in mortgages and mortgage-backed securites. These so-called mREITs suffered a severe setback in 2011 as continued economic uncertainty gave investors pause before jumping into these companies. Declining dividend yields have been met with concern as the REIT market became less appealing throughout the last year. Take, for example, Chimera Investment

, which dropped 38.9% in 2011 as its quarterly dividends were cut from 14 to 13 cents in summer, and again to 11 cents in December. There is good reason to worry when a drop in dividends hits an asset class that releases most of its profits to shareholders through dividends, but a 21.4% decline in dividends was far below the 38.9% drop in stock value. This suggests that investors began shying away from REITs for another, more complicated reason. That reason may have to do with how REITs, especially the mREITs, work. The primary factor in evaluating mREITs is not the housing market but the bond market. This is because they function by exploiting bond spreads. Companies will borrow money at interest rates tied to short-term bonds and lend it at higher rates tied to longer-term bonds. The larger the gap--or spread--between short-term and long-term bonds, the more profitable the mREIT business becomes. If the Fed keeps its promise to keep interest rates low, bond spreads should remain big, and mREIT dividends should remain high. Since the Federal Reserve has continued to assure the markets that it will not raise interest rates anytime soon, mREITs have been in a particularly strong position. In August, the Fed assured investors that it would keep short and medium-term bond rates at historic lows until 2013, although some analysts expected the rates to stay low until 2014. Then,

, the Fed announced that it would keep interest rates low for 18 months. This means that bond yields between short-term and long-term treasuries should stay at their historic highs. To understand the stability of the REITs business model, look at this chart.

The blue line is the 10 year nominal rate and the green line is the 1 year nominal rate for U.S. treasuries; the gray line is the difference between them. While the spread has shrunk in the past year, it has remained healthy enough to make the REITs more profitable than before the subprime crisis:

Again, the green line is the 10 year rate and the blue is the 1 year rate. Yet most mREITs skyrocketed in 2007, despite thin dividends. In 2007, Annaly Capital Management

had a simple moving average of $15.95 on payouts of $1.04--a respectable yield 6.5%. However, at the stock's current price and dividend, its dividend yield is 13.55%. Partly because the stocks hit lows, causing their dividends to look better to risk-taking investors, the stocks have seen a jump in share price over the past month. However, those gains may start to recede, as the stocks follow the market amidst worries that the American economy is not recovering quickly enough. Recent sharp gains--NLY is up over 5% on the past month and CIM is up over 20%--point to another concern with REITs: their risk profile. Higher dividend yields usually translate to unstability and high risk, and REITs surely classify as some of the riskiest stocks on the market, thanks in part to their use of leverage and exposure to rapidly-changing bond spreads. However, this is a rare moment of stability for the REITs, as long as the Fed keeps its word about maintaining a bond rates at current levels. However, with mumblings about a

coming from the Fed, any investor who did play the REIT market would need to look carefully at the Fed and react fast to any change in direction. One may also want to consider the level of risk involved in each REIT. While CIM has maintained a risky, and volatile, profile, American Capital Agency

has been more stable, since it invests in government-backed securities. The so-called agency mREITs are usually less volatile than the non-agency mREITs, because they limit themselves to government-secured debts. Investors who would like to avoid the risks of REITs by avoiding the residential market will be disappointed. Another class of REITs entirely that focuses on renting commercial properties, such as Getty Realty Corp.

have been bearish (GTY is down almost 40% over the past year), thanks in no small part to lower demand for commercial spaces in America as the economy struggles to recover. These companies are more directly impacted by the state of the economy instead of bond spreads, and their dividend yields--5.94% in the case of Getty Realty--reflect that. However, there are some signs of promise for REITs. These companies are poised to perform in 2012 thanks to a strong year of fundraising. REITs raised more equity in 2011 than ever before--$37.5 billion in total, up 32% from 2010. Many REITs plan to use this money for acquisitions in the coming year. Flush with cash, some of these companies are poised to increase their holdings at a time when real estate stocks have begun to recover and many economists are feeling optimistic about 2012, prompting Joe Coco, a partner at Skadden, Arps, Slate, Meagher & Flom LLP, to predict that this year will be "very robust" for the REITs at the beginning of January. The first month of 2012 proved Coco right, but it remains to be seen if those gains can sustain themselves. Real estate has become the high-risk market of the new decade, and savvy investors can profit with REITs, if they understand the complexities behind this unique asset class.