The use of leverage is how REITs provide a high yield from low-yielding instruments
Mortgage REITs, particularly agency REITs, use leverage to enhance returns. Agency REITs invest solely in government mortgage backed securities – either Fannie Mae, Freddie Mac, or Ginnie Mae. These securities do not have credit risk – in other words, even if the borrower defaults on their mortgage, the bondholder will still get paid the principal and interest they are due, on time. Because there is no credit risk, the yields on mortgage backed securities tend to be low. For example, the latest Fannie Mae TBA went out at 103 9/32, which corresponds to an estimated yield of 2.71%. Note that yields are estimated for mortgage-backed securities. You know with certainty how much principal you will get back, but you don’t know when you will get it back. 30-year mortgages that end up being repaid over 30 years are quite rare. Most mortgages are paid off early, either through refinancing, or a move.
If you look at the dividend yields of the various agency REITs, you will note that they all have trailing dividend yields that are much higher than our Fannie Mae TBA that is paying 2.71%. For example, Annaly’s (NLY)’s trailing yield is 14.4%; American Capital’s (AGNC) trailing dividend yield is over 19%. How are they able to pay investors mid-to-high-teens returns on assets that pay 2.71%? Leverage.
How leverage works
Let’s say a mortgage REIT goes out, does an IPO, and raises $100 million. It can invest that $100 million in a current coupon Fannie Mae TBA and get 2.71%. That is a very low risk/low-return trade. The REIT may take that $100 million and $400 million worth of borrowed money and purchase $500 million worth of Fannie Mae TBAs. The $500 million worth of TBAs would pay interest of $13.55 million. The interest on the borrowed $400 million is $2.08 million, leaving a profit of $11.47 million, which is a return on the original 100 million of 11.47%.
While levering up a Fannie Mae TBA at 4:1 may sound risky, it is actually very conservative compared to the typical home buyer. A conservative home buyer would put 20% down on a mortgage, and finance the rest with a mortgage. So if the house appreciates by 10%, the effect on their equity is an increase of 50%. (Think of it this way: a home buyer puts up $100,000 on a $500,000 house. The house goes up by 10% or $50,000. The gain on the equity is $50,000/$100,000 which is 50%.)