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' FormingAs 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."