Real Estate prices have been rising steadily lately and thanks to rising bond yields, mortgage rates are climbing as well. It can be difficult however for individual investors to participate in the real estate market as owning individual properties involves laying out large amounts of cash and either hands-on active management or costly professional management fees.
One simple way to participate in the hot properties market is through the purchase of shares in a Real Estate Investment Trust (REIT) that owns a diversified portfolio of income producing real estate assets and/or mortgages and is required by law to pass through at least 90% of taxable income to shareholders. REITs are also generally tax-efficient because the dividends are taxed at individual rate, rather than as corporate profits.
Real estate investments played a key role in the financial crisis of 2007-2009. A combination of rapidly rising home prices and lax lending standards - including “sub-prime” borrowing in which mortgages were underwritten on properties owned by unqualified buyers – contributed to a rapid decline in home values and record levels of mortgage defaults.
Housing prices declined more than 20% between their peak in 2006 and September of 2008, and greater than 10% of all borrowers owed more than their properties were worth. The widespread securitization of mortgage notes spread the financial pain of delinquencies and defaults to many major institutions across the spectrum of financial services.
Savvy investors scooped up distressed properties during the crisis and the subsequent recovery has rewarded many of them with handsome profits.
Mortgages as a Real Estate Asset
Another smart investment is in the mortgages of distressed properties, which in many cases can be purchased at steep discounts to the original loan value. As U.S. treasuries pull back off recent highs, income-producing investments like REITs look increasingly attractive.
PennyMac Mortgage Investment Trust (PMT - Free Report) , born in the midst of the crisis in 2008, purchases lightly distressed mortgage notes from banks and lending institutions who no longer want to have them on the books and then uses what the company describes as a “high touch” approach in dealing with the property owners to make the notes perform once again as income-producing assets.
In many cases, because of the discount to face value at which the loans were purchased, PennyMac is in a position to offer loan modifications in rates, terms and loan balances that allow the owners to keep the properties and make payments on schedule. Rising real estate prices mean those owners have a financial incentive to make a deal with PennyMac and stay current on their payment schedule.
Attractive financing through the Ginnie Mae MSR financing structure allows Penny Mac the borrow at rates that are much lower than the portfolio of loans it owns.
Using an industry-leading platform to pursue opportunities in the mortgage markets, PennyMac has a strong history of earnings growth, while remaining focused on quality and governance. Steady earnings from its growing portfolio allow the company to consistently pay a dividend in excess of 10% annually. They have paid a double-digit dividend in each of the previous 20 quarters.
PennyMac reported earnings of $0.35/share in Q1, beating the Zacks Consensus Estimate of $0.31/share. Full-year 2018 earnings are now predicted to be $1.66/share, 27% higher than in 2017.
PennyMac is a Zacks Rank #1 (Strong Buy).
Earnings were spread across the company’s three divisions, Production, Servicing and Investment Management. While rising rates hurt production revenues as fewer new loans were originated, the shortfall was more than made up for in servicing, where PennyMac benefited from higher mortgage rates. Notably, the company ended the quarter with $137million on the balance sheet, a 300% increase over the previous quarter.
Aren’t High Dividends a Red Flag?
In many cases, investors are wise to steer clear of stocks that pay very high dividends on the logic that if the market is not valuing the shares based on the yield, either the future of the dividend is in doubt, or the company has operational difficulties that are likely to drag the share price lower.
This is generally good logic, though neither seems to be the case right now with PennyMac. REITs certainly have different characteristics than conventional stocks and while rising mortgage rates and home prices have helped PennyMac for the past decade, a reversal in either of those trends would hurt the company.
This is not an "income" stock for investors who need the income to live, but as part of a diverse portfolio, a 10% yield is hard to pass up.
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