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What Are Mortgage REITs?
Mortgage REITs (mREITs) are a type of REIT that invests in mortgages and mortgage-backed securities (MBS), making them a good alternative to buying a rental property.
Mortgage REITs provide financing for real estate by purchasing mortgages or mortgage-backed securities from banks and other originators.
mREITs offer a simple way to hold an equity investment in the mortgage market with the liquidity and transparency of publicly traded equities, advantages not available through direct investments in mortgage loans and mortgage-backed securities.
Mortgage REITs provide a critical economic function by facilitating the housing market. According to REIT.com, mREITs help finance 1 million U.S. homes. Without mREITs, Access to credit: Mortgage REITs provide liquidity to the mortgage market by buying mortgages and mortgage-backed securities, making it easier for homeowners and businesses to obtain mortgages.
How Do Mortgage REITs Work?
mREITs do not own any physical real estate like traditional Equity REITs. Instead, mortgage REITs invest in mortgages and mortgage-backed securities issued by banks and other institutions.
Mortgage REITs use the money raised through short-term debt securities like repurchase agreements (repos) or common/preferred equity offerings to finance the purchase of their investments.
Mortgage REITs rely heavily on borrowing, so the difference between the cost of raising financing and the interest earned on their investments is their net interest margin, which is the primary way mortgage REITs make money.
How Do Mortgage REITs Make Money?
Mortgage Real Estate Investment Trusts (mREITs) make money through interest and capital appreciation on their investment, not through rental income like equity REITs.
Interest income: mREITs earn income by collecting interest payments and MBS they hold. They typically invest in mortgages with higher interest rates than they pay on the cost of financing they use to fund these investments.
Capital appreciation: mREITs may also appreciate if interest rates fall, leading to an increase in the value of the underlying mortgages and mortgage-backed securities.
How Do Interest Rates Affect Mortgage REITs?
Because mortgage REITs do not own physical real estate property, the rise and fall of interest rates can significantly impact the value of mREITs.
mREITs tend to benefit from low-interest rate volatility because it reduces prepayment risk, and there is a large spread between borrowing costs and the rate they can earn in the market.
It’s important to note that the effect of interest rates on mREITs can be complex and is not always straightforward.
Convexity
Mortgage REITs, specifically mortgage-backed securities, are subject to a statistical concept called convexity.
Put simply; convexity means the value of an MBS security will increase or decrease non-linearly compared to a treasury bond of similar maturity.
Spread Compression
mREITs also make money by earning a spread between the interest they earn on their mortgage assets and the interest they pay to service their debt.
Most mortgage REITs rely on short-term financing but hold long-term investments.
So, when interest rates rise, their cost of financing will increase, but the rate of return on their investment will be static, thus compressing their spreads and decreasing profitability.
Refinancing
Another way interest rates affect Mortgage REITs is through refinancing. As interest rates fall, borrowers may be more inclined to refinance their mortgages at lower rates.
This can lead to prepayments and early repayment of the mortgages, which will impact the value of mortgage-backed securities.
Leverage
mREITs often use leverage, borrowing money to invest in mortgages and mortgage-backed securities.
When interest rates rise, the cost of borrowing also increases, which can negatively impact the mREIT’s profitability.
For example, mREITs may use hedging or other strategies to mitigate the impact of interest rate changes on their portfolio. If executed correctly, hedges should offset any gains or losses due to changes in interest rates.
PROs and CONs
Pros of Mortgage REITs
- High dividend yields: mREITs often pay high dividends, providing investors with a steady income stream.
- Potential for capital appreciation: mREITs may also appreciate if interest rates fall, leading to an increase in the value of the underlying mortgages and MBS.
- Diversification: mREITs can provide a way to diversify a portfolio with exposure to real estate without the need to buy and manage the physical property.
Cons of Mortgage REITs
- Interest rate risk: mREITs are sensitive to changes in interest rates, and their value can decrease if interest rates rise.
- Credit risk: mREITs are exposed to the credit risk of the borrowers whose mortgages they hold, and if many borrowers default, the value of the mREIT could be negatively affected.
- Leverage: mREITs often use leverage to increase their returns, which can amplify the effects of interest rate changes and credit risk, but also increases the risk of loss.
- Less control: Unlike rental property, mREITs investors have less control over the properties or mortgages they invest in.
How To Invest in Mortgage REITs
There are several ways to invest in Mortgage Real Estate Investment Trusts.
Purchase shares of an mREIT through a traditional brokerage
Many mREITs are publicly traded companies, and their shares can be easily purchased through a brokerage account, just like any other stock.
This is the most common and easiest way to invest in mREITs.
Invest in a REIT ETF or REIT Mutual Fund
There are several mortgage-focused REIT ETFs and Mutual Funds. Investing in an ETF or Mutual Fund can provide a more diversified exposure to the mREIT sector.
REITs and mutual funds are good options for those who want to diversify their holdings or don’t want to avoid picking a single mREIT.
Invest in a private placement
Some mREITs may offer private placement opportunities to accredited investors.
Private placements are not publicly traded and usually have less stringent reporting requirements. However, they typically have high minimum investment and are difficult to buy or sell compared to publicly traded mREITs easily.
Who Should Invest in Mortgage REITs?
Mortgage REITs can be a suitable investment for certain investors.
Here are some characteristics of investors who may be well-suited to consider investing in mREITs:
Mortgage REITs are good for…
- Investors who are comfortable with higher risk. mREITs are considered higher-risk investments due to their sensitivity to interest rate changes and credit risk.
- Investors looking for high yield. mREITs often pay high dividends, providing a steady income stream for investors.
- Investors looking for diversification. mREITs can provide a way to diversify a portfolio with exposure to real estate without the need to buy and manage the physical property.
Mortgage REITs are NOT good for…
- Investors who prefer a more diversified portfolio. Some mortgage REITs may have a high concentration of investments in a specific type of mortgage or geographic region, which can increase the risk of loss if that market or sector experiences a downturn.
- Investors who can’t monitor market conditions, trends and interest rate movements as they are more likely to be affected by changes in interest rates.
Largest Mortgage REITs
Some of the largest publicly traded mortgage REITS include:
- Annaly Capital Management Inc (NLY)
- AGNC Investment Corp (AGNC)
- Starwood Property Trust Inc (STWD)
- New Residential Investment Corp (NRZ)
- Blackstone Mortgage Trust Inc. (BXMT)
The Bottom Line
Mortgage REITs present an interesting investing opportunity.
Individuals should consider how adding mREITs would impact their overall diversification and risk of the portfolio.
It is essential to conduct thorough research and fully understand the advantages and risks before investing in mREITs.
Learn more about REITs: Read our Ultimate Guide to investing in REITs.
