My son is almost 2, and my wife and I are already all-in on saving for college. So far, we've put most of his college fund into shares of growth companies that he interacts with: toy companies, streaming media companies, and stores that he likes to ride around the cart in. But recently, we decided it was time to start adding a little diversification to his portfolio with real estate stocks.
The stocks we'll add should provide some dividend income, but because this is a tax-free brokerage account, we'll just be reinvesting those payouts. What we're really looking for is diversification with some growth. And to get it, we've chosen two REITS -- New Residential (RITM) and Medical Properties Trust (MPW -0.54%) -- and online real estate marketplace Zillow Group (Z 0.96%) (ZG 0.81%).
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New Residential
New Residential isn't a typical REIT, which owns real estate and leases it. It is a mortgage REIT -- it invests in mortgage-backed securities and mortgage servicing rights. Like other REITS, it is required to pay out the majority of its income in dividends. At the current share price, its dividend yield is 8.8%.
Most mortgage REITs borrow money using short-term loans, then turn around and invest it in mortgages. As long as the company has a good credit rating and can secure low-cost debt and quality mortgage investments, it will churn out income on the spread between the two rates. The problem with that model is that it becomes harder to manage when interest rates go up.
Because there is usually a mismatch in the loan terms between the REIT's liabilities and assets, it will have to regularly refinance its expiring short-term loans. When interest rates are on the rise, it has to borrow new funds at a higher cost while the rates it is receiving on its long-term investments stay the same. That will squeeze its margins over time unless the REIT is able to acquire lew loans with higher rates. Fears that increases in interest rates were inevitable -- and then the actual arrival of those increases -- have hammered most mortgage REIT stock prices over the last few years. New Residential has mostly proven resilient to the trend so far. Its stock is actually up around 5% over the last year and year to date.
New Residential does own a lot of mortgages and mortgage-backed securities, but it's the company's portfolio of mortgage servicing rights that has set it apart from its hard-hit peers.
Mortgage servicing rights (MSRs) are sold with every mortgage origination. The owner of those rights is paid a servicing fee to collect payments, send statements, make annual escrow payments (i.e., property tax and insurance), etc. The value of mortgage servicing rights goes up when interest rates go up because that reduces the odds that the borrowers will refinance their mortgages.
In the first quarter of 2022, New Residential reported a sequential increase in MSR net income of $788 million, from $118 million in Q4 2021 to $906 million.
I've invested in mortgage REITs before and have always been left unsatisfied with my results because interest rate moves have weighed on their stock prices and book values. But New Residential should do well in any interest rate environment, and keep churning out dividends (which I'll buy more shares with) over the next 15 years.
Medical Properties
New Residential offers some interest rate immunity; Medical Properties provides an inflation hedge. Most real estate stocks can do that to some degree because property values rise along with inflation. The problem comes when a REIT can't raise rents as quickly as inflation because economic headwinds leave some of its tenants unable to make their rent payments.
Medical Properties doesn't have to worry as much about that. It specializes in hospitals and medical offices. Its tenants provide one of the most inelastic services on the market: healthcare. Even if costs go up 10% or more for the REIT's tenants, they will be able to raise prices to compensate and keep making their rent payments. Meanwhile, its real estate's values will increase.
Additionally, Medical Properties builds automatic and inflation-based escalators into its net leases. Under the net lease model, the tenants cover the variable expenses of the properties they occupy, such as insurance, maintenance, and property tax. That allows Medical Properties to fix its costs, which are mostly financing related, and steadily grow its revenues.
Zillow
While investments in the two REITs discussed above should compound over time with steady growth and reinvested dividends, Zillow is more of a lottery ticket growth stock. Like many growth stocks, it has been crushed in 2022 -- down around 35% year to date -- and has been in a steady downtrend since early 2021 as its attempt to enter the house flipping business proved an expensive failure.
Zillow management has shut down its house flipping arm and is now focused on growing the use of its all-in real estate app. The company already has significant market share among home buyers: 4.1 million would-be buyers shopped using its site in 2021, 1.4 million of those found their agent using the site, and 360,000 did a transaction through Zillow.
The next step for the company is to convert that user base into revenue. According to a recent company presentation, Zillow earned an average of $4,100 per transaction in 2021. Most of that came from buyer referral commissions.
The company believes that its fully integrated app could bring in additional revenue by offering buyer and seller agent referrals, title services, mortgage processing, mortgage servicing, and rental services.
It also has growth potential from converting users into customers. Less than 10% of the active buyers who used the site actually made a payment (directly or indirectly) to Zillow last year. It has plenty of room to significantly increase both its customer conversion rate and the average transaction spend.
Of course, revenue conversion is often the rub for e-commerce growth companies. Zillow's management team has done an amazing job of building its brand and growing its user base. If it can convert its name recognition into revenue growth, we'll be happy with the stock.
Keeping a long-term mindset
The good thing about investing for college with 15-plus years to go is that we can keep a long-term mindset. If Zillow falters or one of the REITs hits an unforeseen hurdle, we can reevaluate the business model and potentially hold on through some short-term pain. We have plenty of time to wait for a recovery, and can keep reinvesting our dividends along the way.
