NEW YORK (TheStreet) -- Debt leverage in real estate is no different from leverage in other investments; the more debt you use, the greater potential for gain or loss. When we buy stocks on margin, we are simply leveraging investment returns with debt. Mortgage REITs and other assets carried on high margin involve substantial risk, since a small decline in the asset's value will cause a much larger decline in principal.
Mortgage REITs are especially sensitive to fluctuating market conditions and interest rates as they employ leverage from 5-times to 9-times and require constant repurchase agreement financing. As a result, mortgage REITs must hedge their portfolios using a variety of instruments (IOs, swaps, swaptions) and hope the hedges behave and perform as expected.
Although a modest amount of debt is not terribly dangerous, using too much is not prudent. The most risk-averse REITs have been able to utilize modest leverage when it doesn't compromise the strength of their balance sheet. Essentially, a weak balance sheet (marred by excessive leverage) is simply like an unconditioned athlete and that's why the strongest survive.
As an intelligent REIT investor, it's my duty to persuade investors to avoid dangerous investment strategies and adopt sound ones that are designed to preserve and maintain their hard-earned capital; that's why I called it "sleep well at night" investing.
'Margin of Safety' Forming
As a self-described "value investor" it's my primary goal to preserve capital and controlling risk in your dividend portfolio should be an essential element to your investment process. As the acclaimed investor and author, Howard Marks, explains (from "The Most Important Thing"):
"...there are two main risks in the investment world: the risk of losing money and the risk of missing opportunity. You can completely avoid one or the other, or you can compromise between the two, but you can't eliminate both. One of the prominent features of investor psychology is that few people are able to (A) always balance the two risks or (B) emphasize the right one at the right time. Rather, at the extremes they usually obsess about the wrong one... and in so doing make the other the one deserving attention."
Today we are seeing the return of the bear market in REIT-dom. Unlike the REIT bull market we experienced early in the summer (when most REITs hit all-time highs), the REIT markets are now moving back down and for a value investor, the most beneficial time to buy is when the market is falling.
Read: Top 5 Myths About Home Buying Today
After all, a market downturn is the true test of an investment philosophy so whenever the financial markets fail to fully incorporate fundamental values into securities prices, an investor's "margin of safety" is increased. As Benjamin Graham believed, buying companies trading below intrinsic value leaves a cushion for error, thus giving you a "margin of safety" in case your analysis of the stock's value is too high.
Since REIT prices have begun to fall (in late May) shares have moved closer to fair valuation ranges. Although commercial real estate fundamentals remain sound, Mr. Market continues to value REITs based more on economic data than on true real estate values. For some REIT investors (and value investors) the price fluctuations have created a bargain element that helps cushion the risk of loss while also providing higher risk-adjusted dividend yield options.
Several REITs that appear to be moving closer to the "budget basket" include
Omega Healthcare Investors
Chambers Street Group
Arguably, Digital Realty is perhaps a bargain-priced REIT and the others are getting closer to the segregated REIT class considered to be a "bona fide investment opportunity." As Graham defined it, the margin of safety constitutes a "favorable difference between price on the one hand and indicated or appraised value on the other."
At the time of publication the author held HCP, O, DLR, and CSG.
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.