Table of Contents
Co-produced with Beyond Saving
Invest In Real Estate Now, Opportunity Won’t Last
For the past few months, we have been discussing how strong the residential real estate market has been despite the economic impact of the pandemic. While Wall Street has been very skeptical, but the strength is undeniable.
Interestingly, while the fundamentals are proving to be very strong, many residential focused investments are very cheap, with many trading at multi-year-low valuations. Today we take a look at three different ways investors can take advantage of the strong residential market and achieve high-yields from this very strong sector.
Way #1: Non-Agency Mortgages
For single-family homes, homeowner equity continued to climb in Q2 2020 despite the pandemic. Homeowner equity increased $620 billion, or an average of $9,800 per home. This means that the number of mortgages that are underwater continues to diminish and the vast majority of mortgages are under 80% loan-to-value.
Meanwhile, the price for investors to buy mortgages has materially declined. Investors today can buy mortgages cheaper, while the value of the collateral real estate is climbing.
One way investors can gain exposure to this is through non-agency mortgage backed securities (‘MBS’). These are packages of mortgages that are sold to investors who then hold them, collect the cash-flow and have the option to sell them in the future.
Improving equity positions helps non-agency MBS is a few ways. First, a homeowner with significant equity in a home is very unlikely to walk away. If you have a $300,000 home, it might make sense to let the bank foreclose if the mortgage is $290,000+ and you can’t pay it. If the mortgage is 80% “Loan-to-value” (or LTV) and you only owe $240,000, you are not going to walk away from $60,000+ in equity because you are struggling with the house payment. You will sell your house first.
Second, in the event that a foreclosure does happen, it means that the recovery is going to be far more substantial. In fact, the recovery could be greater than 100% as the recovery is based on the face value of the mortgage, not the price the mortgage was bought for.
The fundamentals are improving, but the price of non-agency MBS remains low. Higher collateral value means lower risk for MBS investors and the market is not reflecting that.
Our favorite pick to take advantage of this reality is PIMCO Dynamic Credit Income Fund (PCI), currently yielding 10.3%. Approximately half of PCI’s investments are in legacy non-agency MBS. These are MBS that were originated prior to 2009, so the homeowner has been paying on them for a long time. PIMCO estimates that the holdings of PCI average about 60% LTV.
PCI has maintained their $0.174 monthly dividend in the face of the March sell-off. With the housing market so strong, we fully expect that PCI will have no problems maintaining their dividend. Despite very strong fundamentals, PCI has not recovered much since the March selloff, opening the door for a unique buying opportunity!
In time, the market will realize the strength of mortgages and PCI’s NAV will recover as well. Investors here are locking the high yield for the very long term, with a nice upside potential!
Other options investors have for investing in non-agency MBS are mortgage REITs (mREITs). We hold several in our model portfolio, however not all mortgage REITs are the same. Picks in this space need to be carefully vetted to get the best yields and the best bang for your money.
Way #2: Agency Mortgages
A big reason why housing prices is up is that mortgage rates are near record lows. Agency MBS are mortgage-backed securities which have the principal guaranteed by a Government-Sponsored Enterprise (or GSEs) like Fannie Mae and Freddie Mac. Since the vast majority of mortgages are bought by GSEs and then resold to investors as agency MBS, the agency MBS market has a huge impact on mortgage rates.
Mortgage rates are near record lows:
Source: Mortgage News Daily
These low mortgage rates are directly attributable to the market price for agency MBS which has climbed substantially this year after selling off in mid-March.
Source: Mortgage News Daily
These MBS are the assets that agency mREITs buy. With the Federal Reserve promising to keep rates low for at least the next three years, and continuing to buy agency MBS in their open market program, we can expect prices to be very stable.
Meanwhile, the cost of borrowing for agency mREITs has plummeted allowing them to borrow funds well under 1%. Agency mREIT earnings were up substantially in Q2 2020 and there is more room for improvement.
One of our favorites in this sector is AGNC (AGNC) yielding 10.3%. AGNC reported a tangible book value of $15.74/share as of July 31, meaning that they are trading at a 12% discount to book value.
Meanwhile, AGNC’s net interest spread increased dramatically in Q2:
Source: AGNC Q2-2020 Presentation
This is going to increase cash flow and lead to rising dividends. We have several agency mREITs in our portfolio and this is one of our favorite subsectors to invest in today. Like PCI above, AGNC is trading at multi-year low valuations and is an incredible opportunity!
Way #3 Buy Apartments
Homes are not the only residential properties that have been strong. Apartments have defied Wall Street’s expectations. Many have been stating a belief that after the federal stimulus was spent in May that people would stop paying rent. Then in August, the theory was that the end of supplemental unemployment would lead to rising delinquencies. Most recently, Wall Street was convinced that eviction moratoriums in place through the end of the year would cause a spike in non-payments.
The apartment apocalypse apparently missed the memo and unsurprisingly to us, most people are still paying their rent. Rent collections are slightly lower than last year, but have been consistent.
Publicly traded REITs generally have above-average properties, so it isn’t a surprise that their rent collections have exceeded the national average. Compared to other types of REITs, multi-family has held up extremely well.
Keep in mind that residential apartments typically have the lower collection rates during “normal” times. There is always a certain number of tenants that can’t or won’t pay rent and get evicted. That is the nature of the apartment business. The bottom line is that people have a tendency to prioritize paying for the roof over their head. This is one of the reasons why multi-family REITs have been so successful.
There are a lot of apartment REITs we like, one of them is Equity Residential (EQR), yielding 4.3%. EQR has a great track record, growing the dividend at an average of 5% annually over the past 10 years.
Over the long-haul, EQR has dramatically outperformed the S&P 500.
The recent dip is a fantastic buying opportunity that comes around once a decade or less.
The secret to EQR’s success has been a focus on markets that have above average rent growth and occupancy.
Source: EQR Presentation (Note the gold cities are places where EQR owns property)
These are still premium locations and EQR is well-positioned to thrive. The fears running around today are the exact same fears we saw in 2008-2010 during the GFC. In hindsight, that was a great time to be loading up on EQR. If you missed it back then, don’t make the same mistake today. EQR’s price has not recovered much since the market crash earlier this year, and offers an incredible opportunity!
EQR trades today at around $55.60 a share while it was trading above $80 back in March. My price target for EQR is above $80 per share over the next 12 months, offering 44% upside potential in addition to the generous yield of 4.3%. This high yield is very rare for such a high quality company.
EQR is a great long-term investment that falls squarely into the dividend growth style of investing. Buy today, and watch your income stream grow!
We could talk all day about the numerous opportunities in residential real estate. These 3 picks have very different approaches. You can own non-agency mortgages directly through PCI, benefiting from a strong residential market and the growing value of the collateral underlying the loans.
AGNC offers the opportunity to invest in the mortgage space without credit risk since the mortgages are guaranteed by Government Agencies. They profit from the spread between current mortgage rates and their cost of borrowing. While mortgage rates have declined, the cost of borrowing has declined further, allowing AGNC to collect a much larger spread than they have in recent memory. The Federal Reserve has been very outspoken about their intention to provide stability and keep the target rate low. Today AGNC trades at a big discount and yields 10.3%.
Last but not least, directly buying real estate when prices are low has historically proven to be an extremely wise decision. Today we can buy EQR at very low prices and collect 4.3% in dividends off of the rising rents in some of the premier cities in the US.
Don’t invest in expensive technology stocks! Buy instead into the cheap residential sector for a more conservative approach to investing. The dividends are a great plus! All 3 picks benefit from a strong residential market in different approaches, offering upside potential in addition to boosting your cash flow.
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Disclosure: I am/we are long PCI, AGNC, AND EQR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Treading Softly, Beyond Saving, PendragonY, and Preferred Stock Trader all are supporting contributors for High Dividend Opportunities.