House On Money

Image: 401kcalculator.org via Flickr

Real estate investment trusts, or REITs, are divided into two main varieties -- equity REITs, which invest in properties, and mortgage REITs, which buy pools of mortgage-backed securities. Mortgage REITs are further separated into two types -- agency and non-agency.

How mortgage REITs operate
The basic business model of a mortgage REIT is to buy mortgage backed securities (MBS) in order to collect the interest payments from the underlying loans. In order to supercharge their income mortgage REITs tend to use large amounts of leverage (borrowed money) to buy MBS.

For example, let's say that a certain REIT wants to purchase $10 million worth of mortgages, which come with an average interest rate of 4%. It may use $2 million of its own capital and borrow the remaining $8 million at a relatively low short-term interest rate, say 2%. So, it collects 4% interest on the $2 million in mortgages it paid for in cash, as well as the 2% spread between the mortgages' interest rate and the cost of borrowing money on the other $8 million.

This is how mortgage REITs can offer such high dividend yields, often in excess of 10%.

Agency vs. non-agency
These terms refer to the types of mortgage-backed securities the REITs can buy. Agency securities are mortgage bonds issued by Fannie Mae, Freddie Mac, or Ginnie Mae -- the government-supported agencies that guarantee mortgages. The mortgages represented by these securities are guaranteed by the issuing agency that the principal amount of the loan will be repaid.

Non-agency securities (also referred to as "private label" MBS) refer to MBS that are made up of mortgage loans that are not guaranteed by one of these agencies. For example, jumbo loans (mortgages above a certain dollar amount) are not eligible to be guaranteed, nor are loans on commercial properties. Non-agency MBS also includes subprime loans, such as those that contributed to the 2008 financial crisis. These securities tend to pay higher interest rates than their agency counterparts, but are subject to default risk in the event that the underlying mortgages stop getting paid.

Risk of a mortgage REIT depends on several factors
As we already mentioned, one of these risk factors is of course the type of mortgages the REIT buys (agency vs. non-agency), but an even bigger risk factor is the amount of leverage used.

Because mortgage REITs rely on short-term borrowing, they are rather vulnerable to interest rate risk. Consider the earlier example of the mortgage REIT that borrows money at 2% to finance mortgages paying 4%, keeping in mind that mortgage REITs borrow money over the short-term in order to get low rates, while the mortgages they purchase will pay the exact same interest rate for 15 to 30 years.

So, if the short-term borrowing rate spiked to 3%, the profit margin is cut in half. If it spikes to 4%, the profit margin disappears entirely. And, if the short-term borrowing rate spikes beyond 4%, well, that's really bad news.

Of course, the actual business of a mortgage REIT is a little more complicated than this. There are ways these companies can protect themselves against interest rate spikes. However, the basic idea of interest rate risk is a legitimate concern for mortgage REIT investors.

The bottom line on mortgage REITs
Mortgage REITs can pay extremely high dividends, but are inherently risky investments, especially during periods of interest rate uncertainty. Before buying shares of any (agency or non-agency) mortgage REIT, it's important to know exactly what you're getting into and to not invest with any money you can't afford to lose.

The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus. Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at knowledgecenter@fool.com. Thanks -- and Fool on!

The Motley Fool has no position in any of the stocks mentioned. 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 Motley Fool has a disclosure policy.