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Subprime
Lending Fiasco Vs. REIT Investors
It’s time to answer your mail. However, this time,
I’ll deal exclusively with subprime lending, an issue that
seems to be on everybody’s mind, particularly as
to how the topic affects real estate investment trusts. As usual,
each question is a composite of several similar questions.
Q. What are
subprime loans and what’s all the fuss about?
The subprime loans in the news are mortgages granted
to homebuyers with poor credit ratings and/or who don’t have enough cash
to make a significant down payment. Making such loans wasn’t a problem
until recently because rising home prices and a strong resale market made
it easy for marginal borrowers to refinance or sell their homes.
Now, with flat prices and few sales, those options
are no longer viable, and recent estimates say that as many as 12%
of all subprime borrowers are behind in their payments.
Q. Can I
profit from the subprime lending fiasco by investing in
real estate investment trusts that have been wrongly depressed by
the news?
Many of the firm’s making subprime loans were real
estate investment trusts (REITs).
REITs are a special type of corporation that doesn’t
have to pay corporate taxes as long as it distributes most of its profits
to shareholders as dividends. While most REITs invest in properties such
as shopping centers or office buildings, mortgage REITs are in the
business of setting up new mortgages or investing in existing mortgages.
Some REITs target the single-family residential market while others
specialize in commercial properties.
Investors buy REITs for the dividends. Instead of
worrying about valuation ratios such a price to earnings, REIT investors
focus on dividend yield, which is the return on investment solely from
dividends. It’s calculated by dividing the next 12-months’ expected
dividends by the current share price. For instance, the yield would be 10%
if you expect to receive $1 in dividends from a stock currently trading at
$10 per share. Assuming that the expected dividend doesn't change, the
yield to new buyers goes up when share prices drop.
The subprime problem has forced down the share prices
of all residential mortgage REITs, increasing the estimated dividend
yields to as high as 15% or so, whether or not
they are involved in subprime lending. That’s why many readers wondered if
that created an opportunity to profit from the unusually high yields by
picking up mortgage REITs not involved in subprime lending.
The answer is no for all
residential mortgage REITS, mainly because the estimated dividend
yields you see listed on financial sites are misleading. They are
calculated assuming that the firm will continue to pay, unchanged, its
last announced dividend for the next 12 months. That’s unlikely to be the
case for any residential mortgage REIT.
Whether in the business of generating new loans or
simply investing in existing mortgages, in my experience, mortgage REIT
profits rise and fall with the dollar volume of new loans generated.
The housing market was already weak and the
unrelenting subprime mortgage news coverage is making matters worse. Thus,
it’s likely that the housing sales numbers will continue trending down for
some time. Declining home sales translate to reduced mortgage demand,
which, in turn, pressures mortgage REITs’ profits, forcing them to cut
dividends. So, at least in my view, all mortgage REITs substantially
involved in the residential market will probably cut their dividends over
the next few months, especially if the residential real estate market
implodes.
Q. I own a
REIT that isn’t involved in residential
mortgages. Will it be hurt by the subprime lending problems?
Once again, the answer is no.
The market for commercial, industrial, and
multi-family residential real estate is booming. Even when the economy was
in the doldrums three or four years ago, investors were busy scooping up
properties in anticipation of better times ahead. Now, buoyed by
relatively low interest rates, private equity firms are flush with cash
and looking for large properties, or even entire publicly traded real
estate investment trusts, that they can purchase.
So, even though property REIT share prices have
already moved up substantially, reducing dividend yields, it’s hard to
envision a scenario that would drive their underlying property values
down. That doesn’t mean that some REITs won’t make bad decisions and
overpay for properties, so do your due diligence.
The same principle applies to mortgage REITs
specializing in financing commercial properties. Rising property
values will likely bail out marginal borrowers. That said, just in case,
once again, do your due diligence and avoid mortgage REITs involved in
risky loans.
Due Diligence
As is the case with all stocks, the more you know about a REIT, the
better your investing results. Reading their quarterly and annual reports
filed with the Securities and Exchange Commission (SEC) is a good way to
learn about a REIT’s business. You can find them on the SEC’s site (www.sec.gov)
by selecting the “Search
for Company Filings” link.
Also, it pays to see what analysts think about a
REIT’s prospects. You can see a compilation of analysts’ buy/sell ratings
and earnings forecasts for most REITs on many financial sites. On yahoo (finance.yahoo.com),
get a price
quote and then select
Analyst
Opinion or
Analyst
Estimates. Avoid any REIT where analysts are predicting declining
earnings vs. year-ago, or that most analysts are advising selling.
Thanks for reading my columns and please keep your
questions coming. I try to answer most personally, but sometimes I get
snowed and can’t keep up.
published 4/1/07 |
