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How to Create the Best QE3 REIT Portfolio

NEW YORK (TheStreet) -- Last week's announcement by the Federal Reserve was significant news for real estate investment trust investors. Not because short-term interest rates will be held low for years, nor because of QE3 -- "quantitative easing," round 3.

The announced QE3 news merely commits $40 billion a month of new stimulus funds -- a significant wad of cash. Slightly unexpected was the announced use of that money: to buy Fannie Mae and Freddie Mac bonds in an effort to keep mortgage rates low and pump up the housing market. The idea here: to eliminate housing debt so that Americans will be able to pick up their spending and revive the economy.

After nearly four years of ultra-low interest rates and a tripling of the Federal Reserve's balance sheet -- but with little progress on reducing the unemployment rate -- the Fed has once again come to the rescue (by a vote of 11 to 1).

How Does the Fed's Easing Plan Benefit Mortgage REITs?

Mortgage REITS, particularly agency REITs, continue to provide suitable income for investors seeking good risk-adjusted returns; however, a decline in agency mortgage REIT dividends -- the result of narrower spreads -- could keep many investors on the sidelines.

Annaly Capital Management (NLY), Capstead Mortgage (CMO), Hatteras Financial (HTS), ARMOUR Residential REIT (ARR) and CYS Investments (CYS) are among the agency mortgage REITs that announced lower dividends for the quarter ended Sept. 30 compared to the prior quarter.

Since the Federal Reserve announced QE3, new 30-year, fixed-rate MBS have fallen in yield by about 30 basis points. To counteract the narrower spread, agency mortgage REITs could increase leverage, but the current environment is too risky to do so, as rising interest rates could lower the value of their holdings and extend the portfolio's duration.

Agency mortgages are guaranteed by government-sponsored entities (implying limited credit risk). Conversely, non-agency securities do not carry a similar implied guarantee, making them inherently more risky due to the higher relative credit risk.

A mortgage REIT creates value for shareholders in two primary ways: 1.) growing book value and 2.) generating consistent income for distributions. Mortgage REITs are not for every investor and the following REITs have historically offered the best value to investors: American Capital Agency (AGNC), Annaly Capital, Anworth Mortgage (ANH), Capstead Mortgage and Hatteras Financial.

How does the Fed's new easing benefit equity REITs?

The Federal Reserve's latest round of money stimulus and extended low interest rates should bolster real estate valuations and provide a tailwind for equity REITs amid gradually improving fundamentals. The fundamentals -- gradual recovery in jobs and housing -- indicate a poised pattern of slow economic growth.

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