REITs help investors get the dual benefits of regular dividends and capital appreciation through real estate investments. But what are mortgage REITs, and do they offer better returns than normal ones? We checked them out, and below is what we found.
Real estate investment trusts (REITs) are companies that own, operate, or finance real estate properties that have the potential to generate income.
They were first introduced in the 1960s by Congress to level the playing field for small investors in commercial real estate investing.
Till then, there was no meaningful way for common folks to get into this lucrative segment; only institutional investors had the wherewithal to put in the huge monies required.
A real estate investment trust offered a way for such small investors to pool their money and benefit by investing in this opportunity.
Over the years, REITs have become a popular asset class for those who want passive income in the form of dividends and long-term capital appreciation.
Born from that simple idea, REITs today have divided into three types of real estate investing strategies:
- Equity REITs
- Mortgage REITs
- Hybrid REITs
Equity REITs focus on owning and operating property (residential and commercial) to generate income. On the other hand, mortgage REITs create mortgages or buy mortgage-backed securities that help finance real estate buyers.
Hybrid REITs, as the name suggests, do a bit of both.
What Are Mortgage REITs?
A mortgage REIT (mREIT) creates mortgages or buys mortgage-backed securities (MBSs) that help finance sales of real estate.
mREITs can create residential mortgages (mortgages that you take when buying a house) and commercial mortgages (meant for buying and selling commercial properties).
These trusts earn from the difference between the interest payments they get through mortgage takers and the interest they pay back to debtors from whom they raise money. Nearly 145 million Americans today have purchased homes using mortgages created by mREITs.
As an asset class, these securities offer high dividend payouts, long term capital appreciation and are an excellent tool for portfolio diversification.
What Is the Difference Between Equity REITs and Mortgage REITs?
Equity REITs directly acquire, operate, manage and lease income-producing real estate, whereas mREITs create or finance the mortgages needed for them. This creates some fundamental differences in the way they operate and make profits.
For example, mREITs earn money on the spread between interest payments from home buyers vs the cost at which they raised capital to create those mortgages in the first place.
If an mREIT creates a mortgage for a $1 million house, they might charge the home buyer a 3% interest rate on it.
Now, let’s assume that the trust raised the $1 million to create the mortgage by acquiring debt from a large financial institution which they have to pay back with 2% interest.
The spread between the two percentages (3% – 2%) is the mortgage REIT profits (after deducting operating costs such as management fees etc.)
Since their main source of earning is the difference between the two interest rates, mREITs are susceptible to sudden changes in market lending rates.
Rising interest rates immediately increase their cost of funding and, at the same time, may have a negative impact on new mortgages being taken out.
On the other hand, falling interest rates are beneficial for them. Now, let’s consider the case of equity REITs. These trusts earn money through rental income on the properties they own and maintain.
They are not directly impacted immediately by changes in rates. In fact, they might actually benefit from higher rates because buying property becomes more expensive, and more people start to prefer rentals in this scenario.
Do Mortgage REITs Go Up With Interest Rates?
No, mREITs fare poorly when interest rates rise. As mentioned earlier, higher interest rates increase their cost of capital, but the number of new mortgage loans goes down.
In our earlier example, if market rates were to go up to 2.5%, the spread between the earnings of the mREIT and its borrowing costs would go down to 0.5%.
This will significantly reduce its net interest income. Moreover, the value of mortgage-backed securities also falls when interest rates rise for similar reasons.
Lastly, during higher interest rates, delinquencies and loan default risk can also go up, as mortgage takers cannot pay their payments on time. Hence rising interest rates are a very bad time for mortgage REITs.
How Are Mortgage REITs Valued?
The two main methods to value a mortgage REIT include comparing its book value to the market price or its return to equity to the dividend yield.
If the book value exceeds the market price, it is a good opportunity to enter into the security since it is undervalued.
Similarly, if the dividend payout ratio is significantly lower than earnings, there is a buffer for the trust to bear losses without reducing its dividend payouts.
Do Mortgage REITs Pay Dividends?
Yes, just like Equity REITs, mREITs are legally required to pay out most of their net earnings as dividend distributions to shareholders. This requirement was put in place as a safeguard for small investors for whom these products were designed.
It ensures that these trusts remain passive real estate investors and therefore protect the money of those who buy their shares.
How Much Does the Average Mortgage REIT Pay in Dividends?
While mortgage REIT dividends vary significantly based on interest rates, the current average yield is close to 10%.
Dividend payout ratios of mortgage REITs are usually much higher than those of equity REITs, whose current dividend yield is close to 3.4%. As long as mortgage sales keep increasing, their dividend payouts are not impacted significantly, even if rates are rising.
What Are the Risks of Mortgage REITs?
There are four types of risks in mortgage REITs: interest rate risk, credit risks, prepayment or refinancing risk, and rollover risks. Interest rate risk arises due to sudden changes in the prevailing rates in the market.
Credit risk is a factor of how the underlying loans of mortgage-backed securities owned by the REIT are performing. Prepayment and rollover risk depend on borrower behavior. Let us look at all of these in more detail.
Interest Rate Risk
The net interest margin of an mREIT is highly interest rate sensitive. Changes in rates also impact the value of mortgage-backed securities held by these trusts. Managing the risk from both short-term and long-term interest rate volatility is crucial.
Typically, mortgage REITs manage this risk through various hedging strategies such as swaptions, interest rate swaps, interest rate collars, or other futures contracts.
Other ways to mitigate this risk include adjusting maturities and the sale and purchase of assets when interest rates are volatile.
mREITs can deal in both residential and commercial mortgages. Typically, each trust will deal only with one of these sectors. The type of mortgage-backed securities they hold in these two cases is different from each other.
Residential ones usually only purchase mortgage-backed securities that have government backing. However, commercial mortgage REITs often hold private-label mortgage-backed securities as well.
This creates credit risk for them since the performance of commercial mortgage-backed securities depends on the quality of the underlying loan.
If a borrower decides to prepay or refinance their mortgage, the creator of the mortgage has to reinvest the money received as per the current interest rates.
This could be either higher or lower than the original environment when the mortgage was issued.
If the prevailing rates are higher, then the investment might be fruitful. But when interest rates become lower, it might be a loss for the mREIT.
While mREITs normally offer long-term mortgages and mortgage-backed securities, they raise their capital through various means, including short-term debt.
Therefore, it is important for them to keep rolling over their debt, or else they might end up becoming insolvent. However, rolling over short-term debt depends on how this market performs, creating a risk for mREITs.
How Are Mortgage REITs Taxed?
Mortgage REITs, just like equity REITs, are exempt from corporate taxes as long as they distribute 100% of their taxable income to shareholders.
This provision makes dividends from REITs attractive because the shareholder is not impacted by double taxation, unlike dividend income from other corporations.
In many cases, the investor can pay taxes on their marginal tax rate, which may be favorable as compared to capital gains tax, which is what other dividend income is taxed at.
Investors can claim a deduction of up to 20% in taxable income if the dividend they receive from the mREIT is purely through interest income.
Are REITs a Smart Investment?
Yes, REITs can be a smart investment choice, but it depends on your investing needs. REITs are a good choice if you are looking for passive income and long-term capital appreciation.
These securities have traditionally matched the S&P 500 in returns over longer terms and offer excellent regular dividend incomes to passive investors.
mREITs are particularly suited for those traders looking to get high dividend yields.
The performance of these securities is not strongly correlated with other asset classes like stocks. They tend to do well even if stock markets are tumbling.
Instead, their performance depends more on factors such as the real estate market, growing population, rising or falling interest rates, inflation, and how the economy is generally doing.
Their value depends on whether new mortgages are being taken out (in the case of mREITs) or whether rentals and occupancies in rental properties are growing (for equity REITs).
All of this makes them an excellent hedge against poor stock market performance.
They are much more liquid than investing directly in real estate since they are traded over the stock exchanges and have thousands of transactions happening every second.
Mortgage REITs create and buy mortgages and mortgage-backed securities that help house millions of Americans. As a form of investment, they are high dividend-paying securities that also offer significant tax advantages to investors.
However, mREITs are not without their fair share of risks and problems. They are impacted significantly by rising interest rates. They are also subject to credit risk, rollover risk, and risk of prepayment from borrowers.
If you want to purchase an mREIT, look at its book value to market value (it should be higher) and compare its dividend yield with earnings ratio (earnings should be significantly higher).
These indicators will help you understand the health of the security and whether you should put your hard-earned money into it.
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