In May 2013, then Federal Reserve Chairman Ben Bernanke hinted to Congress that the Fed would consider tapering its $70 billion monthly bond-buying program.

The markets reacted swiftly and violently to the news. Investors immediately began pulling money from the bond markets.

[ad#Google Adsense 336×280-IA]Bond yield pushed significantly higher as money outflows scared investors. The event became known as the “taper tantrum.”

The reaction in the U.S. REIT market was just as swift. The total returns of the FTSE NAREIT All REIT Index fell sharply, ending the month down 6.6%. The index lost another 8.5% over the next six months.

The volatility in the REIT sector illustrated the conventional wisdom among investors about REIT prices and interest rates.

REIT prices usually decline when interest rates rise.

This is because higher interest rates reduce the present value of future cash flows. As such, asset prices must come down — all other things being equal. And that’s exactly what happened.

But that doesn’t mean some economic law is in place here. Nor does it mean that all REITs should experience declines equally.

Residential and office REITs can actually rise with interest rates, thanks to the higher demand and rising rents that come with economic growth.

Is There A High-Yielding, Safe REIT Investment Now?

The answer to that question is yes… There is a REIT that currently pays a 10.3% dividend yield. Better yet, that yield is completely sustainable — something not often found with REITs in the face of rising interest rates.

Even more incredible, the stock trades at a discount of almost 10% to its liquidation value, meaning the stock has the potential for price appreciation in addition to its dividend payouts.

What is this fantastic REIT? It’s Two Harbors Investment (NYSE: TWO) — a virtual bank.

So what is a virtual bank? A virtual bank does everything a regular bank does, but it does it without the brick-and-mortar branches. This means there are no tellers or walk-in customers.

But it still lends money like a regular bank. It borrows money at low interest rates and lends it out at higher rates (net interest spread). The collateral for its loans is real estate. In other words, Two Harbors Investment operates like any other brick-and-mortar bank in America.

How Can Two Harbors Yield So Much?

TWO uses leverage to generate its returns like every other bank in America.

JP Morgan Chase (America’s largest bank by assets) has roughly $2.5 trillion in assets and $250 billion in equity. During the year, JPM’s return on assets is approximately 1%.

But its return on equity is around 10%. This means the company is leveraged at 10:1, or ten times.

Two Harbors works very similarly — except they are NOT leveraged 10:1, but at a much more conservative 4:1.

This means that Two Harbors must earn a 2.5% return on its assets to deliver a 10% return on equity based on 4:1 leverage. And since the bank is a REIT, it is required by law to pay at least 90% of its earnings to its shareholders.

Two Harbors produces this return through three segments: commercial, rates, and credit. Its commercial operations are the same as all other commercial banks. The company makes commercial loans using real estate as collateral for loans. The company uses a conservative loan-to-value figure of 62%.

Currently, the bank earns an average of 6% interest on these loans. And given the fact that the majority of these loans are adjustable rate loans, rising interest rates won’t hurt them in the future.

The company’s rates division buys real estate loans guaranteed by the government (called agency bonds). The net interest spread between the cost of funds and the government guaranteed bonds is about two percentage points. Here, the company hedges to protect itself to against rising interest rates. This mitigates most of the risk to Two Harbors.

The last division is credit. This division buys mortgage-backed loans not guaranteed by the government. While the risk is higher than agency-backed loans, the returns on these loans are significantly higher. These loans get purchased at a discount of 60-cents on the dollar and trade at roughly 75-cents on the dollar. The company’s profits are the spread between the two.

The Bottom Line

Finding a safe REIT in the midst of rising interest rates isn’t easy. But it isn’t impossible either.

Two Harbors is currently paying a 10.3% dividend — with only four times leverage. And as the chart below illustrates, the stock is trading at almost 10% below its liquidation value.

That makes Two Harbors the highest yielding safe REIT in existence. Should the stock edge closer to par, a 30% gain is possible in the next 12 months.

Risks To Consider: If the Federal Reserve were to raise interest rates significantly higher and faster than most economists expect, it could exert downward pressure on the stock price. But the stock held up during the taper tantrum, and the risks of higher and faster rate increases are minimal.

Action To Take: Buy shares of TWO up to $9.50. Use a 15% trailing stop. Of course, mitigate your risk by committing no more than 1-2% of your portfolio to Two Harbors Investment. The holding period is 2 years or once the stock has returned 30%.

— Richard Robinson

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Source: Street Authority