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The Basics of Mortgage REIT Investing

Dan Caplinger
September 14, 2012

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 FT