1 Thing You Must Know About Mortgage REITs

With so many investors struggling to generate the income they need from their investment portfolios to make ends meet, high-yielding dividend payers have gotten a lot of attention. Some of the most popular investments that have grabbed the spotlight during years of low interest rates are mortgage REITs, real estate investment trusts that make hugely leveraged bets on the returns of long-term mortgage-backed securities.

With yields that in many cases exceed 10%, some investors never look past the lucrative payouts that mortgage REITs give their shareholders. But as a recent incident involving mortgage REITCYS Investments (NYS: CYS) shows, you need to know some of the risks involved in mortgage REITs if you want to avoid some surprising losses.

The need for capital
Mortgage REITs buy securities that are composed of ordinary mortgages. Most mortgage REITs, including CYS, Annaly Capital (NYS: NLY) , and American Capital Agency (NAS: AGNC) , focus on mortgages that pass the standards of government-sponsored enterprises Fannie Mae and Freddie Mac. A few, such as Chimera Investment (NYS: CIM) , go beyond what are known as agency securities, taking on exposure to mortgages that some other lender originated.

Regardless of which type of securities they buy, mortgage REITs pay their huge yields because of two things. First, they borrow large sums of money at short-term rates, investing the proceeds in even more mortgage-backed securities. These leveraged portfolios produce a lot of income when short-term rates are well below the interest payments that mortgage REITs receive on their mortgage securities. Second, the rules governing REITs force them to pay out substantially all of their income in the form of dividends.

Those high payouts are good for shareholders, but they put the REITs themselves in a position of steadily losing investment capital. That's where the CYS episode comes in.

When secondary offerings cost you money
CYS said yesterday that it had priced a secondary offering of 40 million shares. By doing so, the company could raise more than $600 million in capital if underwriters exercise their option to purchase additional shares.

But the bad news for existing shareholders is that the price at which the sale took place was 3% below where shares traded before the offering. In other words, the buyers in the secondary offering got a much better deal than they could have buying shares on the open market.

As unfair as this seems, though, there's another way of looking at it. CYS had just announced that its net asset value per share as of June 30 was between $13.50 and $13.54 per share. Put in that light, selling shares at $13.70 per share was actually accretive to shareholders -- at least on a net-asset-value basis.

Admittedly, a week and a half into the third quarter, CYS' net asset value might be higher now. But the bigger point is that more so than with many companies, mortgage REITs are closely tied to the value of the assets they hold, and so when shares move too far above net asset value, it's a golden opportunity for the REITs to do secondary offerings.

Watch out
Not all companies provide net asset value estimates in as timely fashion as CYS does. Annaly and American Capital Agency give book value, which is functionally equivalent to net asset value, as part of their quarterly reports, by which time it's often a month out of date. Chimera didn't file its March 31 estimates of book value with the SEC until June 19. Here are the latest available figures:

Sources: Company filings, Yahoo! Finance. *Non-GAAP estimated economic book value.

After watching fluctuations in book value for a while, though, you should be able to get a sense for how much movement is reasonable. If you see your mortgage REIT shares move beyond that reasonable range, then you should be on the lookout for a potential drop from a secondary offering.

Know your dividends
Investments all have their quirks. Only if you fully understand how each type of investment works will you be able to prepare for things that will surprise those who are less aware of its foibles.

If you like dividends but want to go beyond mortgage REITs, we've got some ideas for you. Let me suggest the Fool's special report "Secure Your Future With 9 Rock-Solid Dividend Stocks." Just as its title says, you'll find the names of some of the best dividend companies in the world along with in-depth analysis of why they're the best. This report is completely free, so don't miss out!

At the time thisarticle was published Fool contributor Dan Caplinger always looks for true value. He doesn't own shares of the companies mentioned in this article. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy tells you what you need to know.

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