Investors hunting for yield should take a look at the real estate investment trust (REIT) sector. REITs are unusual stocks in that they're permitted to avoid paying corporate income tax -- provided that they invest in real estate assets and distribute the vast majority of their earnings as dividends to shareholders.
The mortgage REIT space contains several stocks with double-digit dividend yields, including MFA Financial (MFA 1.80%) and its 14% dividend yield. Why do mortgage REITs have such high dividend yields right now? And are any of them good investment candidates?
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Mortgage REITs are different than the typical REIT
MFA Financial is a mortgage REIT that invests in mortgages and mortgage-related products. Mortgage REITs are quite a bit different than the typical REIT and generally have much higher dividend yields.
The typical REIT develops commercial properties like office buildings, apartment complexes or strip malls and then rents out the individual units. It's the classic landlord/tenant business model. Mortgage REITs generally don't invest in property -- they invest in property debt (or mortgages). They collect interest income and borrow to amplify the returns and operate much more like a bank or hedge fund.
MFA Financial is generally considered a non-agency mortgage REIT, which is different than big agency REITs like AGNC Investment, which invests almost exclusively in mortgage-backed securities that are guaranteed by the U.S. government. MFA Financial bears credit risk, while AGNC Investment does not. That being said, mortgage-backed securities without credit risk can still lose money, as investors in SVB Financial's Silicon Valley Bank found out the hard way.
MFA Financial takes credit risk
The company originates and invests in business-purpose loans and mortgages that are not eligible for a government guarantee. MFA also has a large portfolio of non-performing and reperforming mortgages.
These business-purpose loans will generally go to fix-and-flip investors or new construction loans for new rental properties and generally have nothing in common with the subprime loans that helped cause the 2008 financial crisis. Business-purpose loans generally require the borrower to put up substantial equity and demonstrate that rental income will cover debt-service payments.
Last year was difficult for the entire mortgage REIT space, as the Federal Reserve raised the federal funds rate to bring down inflation. This caused mortgages to fall in value. While the mortgage REITs generally hedged against rising interest rates, mortgages, in general, underperformed Treasuries.
Every mortgage REIT out there reported big declines in book value per share, and most were forced to cut their dividends. MFA Financial was no exception, as book value per share declined from $19.12 per share at the end of 2021 to $14.87 at the end of 2022. MFA also cut its per-share quarterly dividend from $0.44 to $0.35 in the fourth quarter of 2022.
Investors should wait until the Fed is done raising rates
The mortgage REIT sector is trading at attractive dividend yields, but the Federal Reserve remains a headwind for the entire loan industry. Rising housing prices during the pandemic and rising interest rates afterward combined to dent home affordability.
Falling affordability has made origination volumes dry up and will put pressure on rents. That said, MFA's business-purpose loans and non-guaranteed mortgages usually require substantial equity, so unless real estate prices crash, the underlying real estate will cover the losses if a borrower defaults.
Once the Federal Reserve wraps up its credit tightening regime, the mortgage REIT sector will be a lot safer. Income investors who are at or near retirement might want to wait until the Fed gives the all-clear signal before investing in the mortgage REIT space. That said, the risks and rewards are becoming more attractive for the sector, in general.
