A lot of income investors own shares of the iShares Mortgage Real Estate Capped ETF (NYSE: REM) as a stock market investment that pays a high (almost 9%) current dividend yield. The problem with REM is that it holds a lot of the highly leveraged – dangerous to your wealth – residential mortgage-backed securities, or as they are regularly referred to (MBS REITs).
For most of the last year, the REM share price has been steadily marching higher. Over the last month the uptrend reversed with the share price declining by about 5%. That drop indicates that for many companies in the fund’s portfolio, higher interest rates and a flat yield curve are a danger to profits and continued dividend payments. A better option for the high-income focused investor is to build a portfolio from the financially strongest stocks out of the REM holdings list.
According to the tax rules that govern its operation, a REIT can own real estate property or participate in the financing of real estate assets. REITs that focus on owning real estate are referred to as equity REITs, while those that focus on the mortgage side of real estate are called finance REITs. The finance REIT side of the REIT universe typically carries much higher dividend yields, which are very attractive to income-focused investors. For comparison, REM currently yields 8.8%, and the largest equity REIT ETF, the Vanguard REIT Index Fund (NYSE: VNQ), yields 4.6%.
A significant number of finance REITs employ a business model that involves owning government agency guaranteed MBS and leveraging their MBS portfolios to turn the 3% bond yields paid by these safe MBS into the cash flow to pay a double-digit dividend yield. Changing interest rates at either the short or long end of the yield curve will eat into one of these company’s cash flow generation ability.
To build a min-REM portfolio that gives a higher yield and does not destroy principal value, the strategy is to buy those finance REITs that have not been slashing dividend rates because their business models failed to adjust for changing interest rates. Here are five stocks out of the REM holdings that have not reduced dividends in the last five years…