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.

Clearly these economic conditions are not robust and this slow-growth environment is good for equity REIT investors. As Jordan Sadler with KeyBanc explains:
This gradual recovery in demand, slow recovery in demand, is good for real estate because you're soaking up space, and it's not yet robust enough to translate into new supply. Real estate landlords and owners are not yet at a point, because the economy's prospects are so muted, where they're looking to speculate in any significant way and looking to go out and build excess capacity. So the risks of oversupply are very low, by and large, throughout the space.

The Fed's earlier stimulus actions, along with prevailing economic conditions and unfettered access to capital markets among REITs, have also driven down required returns for real estate and, in turn, pushed down cap rates -- which equates to higher property valuations.

KeyBank's Sadler explains that the firm is "an advocate of the 'risk on' trade." He adds that his firm "likes the shopping centers . . . and the industrial REITs all year long." And he "thinks we're in an environment where the economy is gradually recovering, and you don't need to pay a premium for quality, and lower leverage, and things that are just going to be safer."

Some of KeyBanc's recommendations include Taubman Centers ( TCO), upgraded by KeyBanc to "hold" from "underweight" In addition, KeyBanc upgraded Kite Realty Group ( KRG) to "buy" from "hold."

Sadler of KeyBanc said the firm is more positive recently on the industrial sector, where he said supply has been muted in recent years. While development has started to increase in many top-tier markets, the report said, demand remains high. The bank upgraded its rating of First Industrial Realty Trust ( FR) to "buy" from "hold."

Slow but steady job growth and very limited new construction are supporting fundamentals in select office markets, though several markets are constrained by high vacancies and weak demand. KeyBanc upgraded its rating of Boston Properties ( BXP) to "hold" from "underweight." It downgraded American Assets Trust ( AAT) to "hold" from "buy."

The specialty office and industrial sector should continue to benefit from strong fundamentals, led by growing demand for data center space. KeyBanc upgraded its rating of BioMed Realty Trust ( BMR) to "hold" from "underweight."

In health care, positive signs for the sector heading into 2013 include the increasing likelihood that President Obama will be re-elected, which could increase health care spending and reduce reimbursement risk. KeyBanc upgraded its rating of Health Care REIT ( HCN) to "buy" from "hold," based partly on its positive view of the company's acquisition of Sunrise Senior Living ( SRZ). It also upgraded Healthcare Realty Trust ( HR) to "buy" from "hold."

Triple-net REITs, which have a longer-term lease structure, will likely see a greater benefit from the Fed's quantitative easing policies, the KeyBanc report said. KeyBanc upgraded its rating of CapLease ( LSE) to "buy" from "hold."

At the time of publication, the author held no positions in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

If you liked this article you might like

Intuitive Surgical, Chicago Mercantile Exchange: 'Mad Money' Lightning Round

Intuitive Surgical, Chicago Mercantile Exchange: 'Mad Money' Lightning Round

A Roaring, Rip-Snorting Bull: Cramer's 'Mad Money' Recap (Wednesday 11/1/17)

A Roaring, Rip-Snorting Bull: Cramer's 'Mad Money' Recap (Wednesday 11/1/17)

Which Way Are These Stocks Going?

Which Way Are These Stocks Going?

5 Amazing Dividend Stocks in This Uncertain Market

5 Amazing Dividend Stocks in This Uncertain Market

10 High-Yielding Stocks to Own Ahead of a Surprising Late Summer Market Swoon

10 High-Yielding Stocks to Own Ahead of a Surprising Late Summer Market Swoon