Market Mad House

In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule. Friedrich Nietzsche

Market Insanity

Do mREITs Make Money?

Mortgage real estate investment trusts, which are known by the cumbersome acronym mREITs in the financial world, are among the weirdest equities being traded these days. They are also among the most confusing because even grizzled Wall Street veterans have a hard time understanding them.

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An MREIT is a confusing hybrid that combines the attributes of an investment fund, a bond and a stock. These constructs are traded on stock exchanges, but they are not really companies; instead, they are pools that invest in mortgages or mortgage-based securities. An mREIT is not a classic company, because it owns no property, provides no services and manufacturers no goods and only earns revenue from the mortgage payments.


It is more akin to an exchanged traded fund, or ETF, than a traditional stock. The difference is that an mREIT invests in mortgages and mortgage-based securities rather than stocks or equities. Naturally, that scares a lot people to death, especially those that remember the 2005–2008 mortgage bubble and meltdown.

Why Some Investors Love mREITs

The similarity between an mREIT and a bond is that investors make their money off high dividend yields rather than increases in value. On September 23, 2015, Annaly Capital Management (NYSE: NLY), one of the best known mREITs, was trading at just $10.47 a share, yet it offered a dividend yield of 11.46%. That means investors made around $1.20 a share from the dividend yield.


Some other mREITs offered even better returns. Invesco Capital Management (NYSE: IVR) was trading at $13.70 a share on September 23, 2015, and paying a dividend yield of 13.50% a share. That translates to a payout of around $1.85 a share. Something called VEREIT (NYSE: VER) was trading at $8.15 a share on September 23, yet it produced a dividend yield of 10.22%. That would equal 83¢ a share. The questionably named Chimera Investments (NYSE: CIM) traded at $14.44 a share and produced a dividend yield of 12.88%, which would give investors a dividend return of around $1.86 a share.

Now you see why some investors love mREITs; they are cheap, yet they offer a high cash return on the investment. A person that bought several hundred shares of something like Chimera or Invesco could get a return of several hundred dollars from the dividends.

The Big Problem with mREITs

The big problem with mREITs is an obvious one: Unlike a bond, they do not provide guaranteed income. A company’s management can shut the dividend off anytime it wants to or anytime it does not have the money.

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That means an investor has no guarantee the income will actually be coming in. It makes mREITs a very poor investment for those that need income from their stocks. That also means that mREITs definitely do not belong in a retirement portfolio. You cannot make much money by selling them, and the high dividend profits could disappear at any time.

The $1 Billion Question

This brings us to the $1 billion question: Do MREITS actually make money? That’s a hard question to answer because of the weird financial numbers these instruments report. The best response to the enquiry I could come up with was sort of, which is bothersome.

Chimera Investments reported no profit margin, no revenue and no net income on June 30, 2015, yet it somehow managed to generate $158.32 million in free cash flow. That money I imagine comes from mortgage interest because Chimera also reported $330.87 million in cash from financing and $340.88 million in cash from operations on the same day.

Now for the risk: Chimera only had $49.55 million in cash and short-term investments on June 30, 2015. That means it’s only source of income could be mortgage interest, since it has no revenues. If that interest stops or the amount falls off, Chimera melts down—shades of 2007!

Such an eventuality might be more likely than we think because Chimera also had liabilities of $12.31 billion. Those liabilities were exceeded by its assets of $15.75 billion, but Chimera also reported a market cap of $2.966 billion and an enterprise value of $2.907 billion. That means what you are really buying with Chimera is a lot of debt, not a company; in other words, a bond.

Why mREITs Should Come with a Warning Label

Therefore it is a good time to remember what our master Warren Buffett said about bonds in his 2012 investor newsletter:

“Bonds should come with a warning label.”

Since they are sort of like bonds, mREITs should also come with a warning label—a big one—because of what they really are. Something to remember is that an mREIT does not own any actual real estate; it owns mortgages, but if the mortgages are underwater, what it really owns is paper. The mortgages can be foreclosed on, but that is an expensive and tedious legal process.


Nor does an mREIT own any physical plant like a store or a factory. If a store or a factory is not producing money, it can be shut down and the real estate and the furnishings sold. Even if you have to sell the furnishings for scrap, you’ll at least get a few dollars.

An mREIT is not what Uncle Warren would call a “productive asset.” A productive asset is something that can produce actual revenue whether it is float from an insurance policies or sales from a store.

There seems to be no way for Chimera to grow, because it has no revenue. Okay, but what about the other mREITs we’ve discussed here; are they making money?

Investments That Sort of Make Money

Well, Annaly did produce some revenue; it reported a figure of $327.38 million on June 30, 2015, which was down from $902.41 million in June 2014. It also reported a net income of $120.59 million and a free cash flow of $456.82 million on the same day.


Now for the truly bizarre angle. Annaly somehow managed to create a negative enterprise value of -$56.50 billion and a market capitalization of $9.928 billion. Yet on the same day it had $70.03 billion in cash and short-term investments and reported making $11.21 billion in cash from investing but losing -$6.416 billion in cash from financing and -$4.334 billion in cash from operations. Those numbers sound great, but Annaly also has accumulated $62.86 billion in total liabilities and $75.55 billion in assets.

The Numbers Do Not Add Up

Annaly also reported a profit margin of 95.32%, which sounds too good to be true to me. Annaly sounds sort of like a pyramid scheme to me. I have to wonder if it is achieving those high dividend rates by simply paying out all the money it rakes in. That inflates the market capitalization, and it is a good deal for investors until the money runs out.

Invesco Mortgage Capital also reported a revenue of $123.36 million on June 30, 2015, an impressive free cash flow of $100.04 million, a net income of $68.88 million, an unbelievable profit margin of 90.57%, $87 million in cash and short-term investments, $219.02 million in cash from financing and $380.52 million in cash from operations. As at Annaly, it looks as if all the money that comes in is going straight out the door in the form of dividends.

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VREIT reported a bigger revenue figure of $1.664 billion, a negative net income of -$767.51 million, a negative profit margin of -27.06%, a free cash flow of $214.92 million, $922.47 million in cash from operations, $121.65 million cash and short-term investments and losing -681.04 million in cash from financing and -$315.31 million in cash from investing on June 30, 2015. VREIT also spent $2.347 billion in capital expenditures, which exceeded its revenue. VREIT supposedly has a market value of $7.37 billion, an enterprise value of $16.9 billion, total assets of $19.25 billion and total liabilities of $10.27 billion.

My take on the situation is that these numbers just do not add up. Something is very wrong here. How can companies with a negative income or no revenue growth pay dividend yields of around 10%? An mREIT does not look like a stock; instead, it looks like a highly speculative bet on mortgage interest.

The Opposite of a Value Investment

The best advice on mREITs is to stay far, far away from them. Any money that you might make from dividends is simply not worth the risk. Mortgage real estate trusts actually look like the opposite of a value investment; instead, they appear to be designed to simply pay a high dividend yield and nothing else.

That dividend yield depends only on mortgage interest. If the economy goes bad and people stop paying their mortgages, the income stops. Since there’s no way to tell when that might happen, nobody should have mREITs in his or her portfolio. They are simply too volatile to be a long-term investment.

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