I came across a prescient article discussing the dangers of mortgage REIT’s, particularly as interest rates begin climbing. These companies’ use huge amounts of leverage to buy mortgage backed securities, and because they pay out the vast majority of net income as a dividend to shareholders’, the companies’ benefit from better tax treatment on the corporate side. This is a similar structure to master limited partnerships (MLPs), which cater towards infrastructure assets, such as pipelines of gathering systems. The problem with both of these structures is that because the companies can’t retain earnings to qualify for the tax treatment, they are forced to continuously access capital markets for debt and/or equity. This works great until at some point, liquidity freezes up, which can put these companies at risk. When interest rates rise, their huge and leveraged mortgage books get written down, reducing book value unless they are completely hedged. There is not as much regulation in this arena, which is also known as “shadow banking.”
Many of these stocks have had wonderful runs over the last several years so they will boast a great track record, but it is important to look forward instead of driving through the rear-view mirror. Often, unscrupulous salesmen will offer private REIT’s with high-load fees, which can be 7-8% up-front. These REIT’s also are not usually liquid and have long and costly lock-up periods. Most often, that commission is paid off of your principal, as is the high stated dividend in the beginning years. I’ve invested in REIT’s and MLP’s in the past so I’m not saying they are all bad at all, but there are risks that don’t get as much discussion due to the recent low interest rate environment, which has made it easy for these companies to raise capital at attractive prices. Be wary of investments offering obscenely high yields in this environment because usually there is a catch to it. This is why I’m a huge proponent of our strategy of selling options. We have the ability to generate high yields on expiring put options on value stocks, while our biggest risk is that we will end up owning these undervalued stocks at prices, which we can’t buy them at today giving us an even larger margin of safety. The biggest risk we are accepting is short-term market to market risks when volatility goes up, increasing the value of our options, but at expiration volatility goes to zero and the only thing that matters is where the stock is trading at relative to the strike prices of our sold options. Thank you very much and as always if you have any questions please don’t hesitate to contact us!
INVESTING IN THE FINANCIAL MARKETS INVOLVES RISKS. OPTIONS ARE NOT SUITABLE FOR ALL INVESTORS.