The Basics of Mortgage REIT Investing

Worldwide Invest Better Day 9/25/2012

The Motley Fool has helped ordinary people become better investors for nearly two decades. This month, we're reaching out to millions of investors to help guide them in their quest toward financial knowledge and independence.

Along those lines, I'm planning to take a look at some different types of investments that many people aren't as familiar with, as well as the popular exchange-traded funds that allow you to make those investments. Today, I'd like to focus on mortgage REITs in general, and on the iShares FTSE NAREIT Mortgage Plus ETF (NYSE: REM  ) in particular.

Why buy mortgage REITs?
Few niches in the stock market have gotten more attention that mortgage REITs over the past several years. The reason is simple: No other investment compares to mortgage REITs in providing high dividend yields. Two of the most popular mortgage REITs, Annaly Capital (NYSE: NLY  ) and Chimera Investment (NYSE: CIM  ) , pay yields in the 12% to 14% range. Another, American Capital Agency (Nasdaq: AGNC  ) , tops 15%.

What makes these monster yields possible is the business model that mortgage REITs have in common. In simplest terms, mortgage REITs buy regular mortgage-backed securities the same way that any investor could. But rather than simply taking money they have, buying mortgage securities, and then calling it a day, mortgage REITs go out and borrow as much money as they can to buy additional mortgage securities, hoping to profit on the spread between the interest rate they pay to borrow and the interest rate they earn on their mortgage-backed securities.

Given that the Federal Reserve has gone out of its way to keep short-term rates as low as possible over the past several years, mortgage REITs have gotten a nice boost. But yesterday's announcement that the Fed will implement the long-awaited QE3 could eventually have an adverse impact on the long-term prospects for mortgage REITs. The Fed said that in its bond buying, it would focus on mortgage-backed securities -- the same ones that mortgage REITs seek to invest in. As a result, prices for mortgage-backed securities will inevitably rise. That's good news for the existing portfolios mortgage REITs own, but it will make it more costly for mortgage REITs to invest in new securities, cutting margins and making them less profitable.

Why buy mortgage REITs through an ETF?
You can obviously buy individual mortgage REITs. But the benefit of using an ETF to buy them is that you get a wide variety of different mortgage REITs under one umbrella. The iShares FTSE NAREIT Mortgage Plus ETF sports nearly 30 different investments in its portfolio, and although some of these securities are regular industrial and office REITs, the vast majority of them are pure mortgage REITs.

For this convenience, the iShares ETF charges you to own its shares. You'll pay annual expenses of around $48 for every $10,000 you invest, which may seem a bit on the steep side for an ETF that owns relatively few investments. Still, with a current SEC-defined yield of 12.41%, you'll get nearly $1,250 in dividends for every $10,000 you invest -- a truly amazing yield.

One thing to be careful about with mortgage REITs is that those dividends, while amazing, aren't guaranteed to last. In particular, Chimera has seen its dividend cut in half over just the past couple of years, while Annaly and Invesco Mortgage Capital (NYSE: IVR  ) have also seen multiple dividend cuts fairly recently. Even after the cuts, these REITs still make impressive payouts, but historically, many mortgage REITs have paid much smaller distributions in the past. If interest rates ever start rising and spreads get narrower, the squeeze in profits could bring on much deeper dividend cuts that would likely pull share prices down as well.

Learn more
Mortgage REITs are a dividend lover's best friend, and the iShares FTSE NAREIT Mortgage Plus ETF represents a reasonable way to get broad exposure to the asset class. To learn more about iShares FTSE NAREIT Mortgage Plus, use this link to the ETF's main information page, and be sure to follow the Fool's coverage on the ETF using our My Watchlist feature. Also, we've recently released a premium report specifically detailing Annaly Capital and its prospects, so don't miss it.

Please stay tuned throughout the month for other informative articles covering a wide range of important topics. Let me also encourage you to take a look at the special website we've set up at InvestBetterDay.com. On Sept. 25, we're taking a day to celebrate the art of investing, and we encourage your participation. Take a look at the site now and get on the path to personal prosperity.

Fool contributor Dan Caplinger got out of mortgage REITs a while back. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy always pays dividends.


Read/Post Comments (4) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 14, 2012, at 4:01 PM, GrampaRick wrote:

    Invesco Mortgage is a great stock and they go ex-div on Sept 20th with a 65 cent dividend. Another great stock is PennyMac "PMT". Their niche is that they buy directly as a correspondent lender to banks, mortgage bankers, & mortgage brokers. They can cherry pick the best loans.

    With the Fed keeping rates low until mid-2015 mREITs are going to have a long growth streak since their prepayments will be lower.

  • Report this Comment On September 14, 2012, at 6:10 PM, bellpa wrote:

    So Dan.

    Considering the looming increase in dividend taxes, where would the best place to hold a REIT ETF?

    I own NLY in my Roth IRA. Would you recommend that as the best account to use -

    or a taxable account or Traditional IRA?

  • Report this Comment On September 14, 2012, at 7:20 PM, HighVoltage627 wrote:

    ~bellpa,

    Thecoming increases for dividend taxes, if it happens, wont mean much of anything for REIT's.

    One of the qualifications for REIT's is that hey pay out most of their income in dividends. This has favorable tax advantages for REIT's. The down side is that REIT dividends dont get the favorable tax treatment that regular dividends do.

    Regular dividends are taxed at 15%. REIT dividends are taxed at the owners regular tax rate, whatever that may be.

    That being said, I belive a Roth IRA would indeed be wonderfull place for you to hold a REIT. A normal tax defered 401k would also work extremely well.

  • Report this Comment On September 17, 2012, at 7:28 AM, TMFGalagan wrote:

    @bellpa - What HighVoltage627 said is right. I think mREITs are great holdings for IRAs of either category.

    best,

    dan (TMF Galagan)

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