3 Top Mortgage REIT Dividend Stocks to Consider Buying Now

Mortgage REITs tend to offer some of the highest dividend yields in the market, but there are a few things investors need to know before jumping in. No stock capable of generating a double-digit dividend yield is without risk, and mortgage REITs are certainly no exception. However, if you understand the risks involved and have a high risk tolerance, a high-dividend mortgage REIT could be a good addition to your portfolio.

Here are three of the highest-paying mortgage REITs, followed by a discussion of how mortgage REITs work and the details behind each of their businesses, so you can choose the best fit for you.

Data source: TD Ameritrade. Stock prices and dividend yields as of 1/23/18.

How mortgage REITs work

Unlike equity REITs, which own and manage properties, mortgage REITs generally invest in mortgages, mortgage-backed securities, and other mortgage-related assets.

Here's a simplified explanation of how the mortgage REIT business model works and how the double-digit yields you see in the table above are possible. Mortgage REITs acquire mortgages, which generally have long maturity terms, such as 15 or 30 years. They finance the purchase of these with short-term debt, which generally comes with a lower interest rate than the mortgages pay. For example, if a mortgage REIT buys a 15-year mortgage that pays 3% per year and finances it with debt that costs 2% per year, the 1% spread represents the profit.

Of course, shareholders aren't interested in earning a 1% or 2% return, so these companies use a great deal of leverage to boost returns. For example, a mortgage REIT with $1 billion in capital may borrow $5 billion to purchase mortgages, which is how they can generate such high returns.

Image source: Getty Images.

Risks and how mortgage REITs deal with them

Since mortgage REITs rely on short-term borrowing, the main risk is rising interest rates. In the above example, if a 15-year mortgage owned by a REIT pays 3%, and the cost of short-term borrowing jumps to 3%, the profit disappears. If short-term borrowing costs jump to 4%, it actually costs the REIT money to hold the mortgage.

Mortgage REITs have ways of hedging against unexpected spikes in interest rates by using interest rate swaps and other types of derivative securities. While the full details of interest rate hedging are beyond the scope of this discussion, the point is that mortgage REITs can (somewhat) protect against interest rate spikes to avoid catastrophic losses.

Even so, interest rate fluctuations are still the primary risk factor when investing in mortgage REITs. In fact, many mortgage REITs lost about 5% of their value over the past week alone as bond interest rates have surged.

With all of that in mind, here are three mortgage REITs that pay some of the highest dividends in the market, and a brief introduction to each one.

A sky-high dividend yield and a diverse portfolio of mortgages

New York Mortgage Trust is the highest-paying mortgage REIT on the list, with a sky-high 14% dividend yield based on the current stock price. The company's objective is to build and maintain a portfolio of diverse residential credit assets.

Surprisingly, New York Mortgage Trust achieves such a high return without using a high amount of leverage. In fact, with a 1.5-to-1 leverage-to-capital ratio, it's among the least leveraged in the mortgage REIT industry.

The company does this by investing in a unique assortment of assets, most of which pay higher yields than traditional mortgages. For example, the bulk of the single-family portfolio consists of "reperforming" loans, which refer to mortgages where the borrower was previously delinquent but has resumed making payments. Another major component is mortgage interest-only securities, which essentially represent just the interest portion, not the principal, of a mortgage's payments. These actually rise in value as Treasury yields rise, making them a nice hedge against rising rates.

New York Mortgage Trust also heavily invests in multi-family mortgage-backed securities, preferred equity investments, and joint venture equity investments.

A high yield with moderate leverage

Two Harbors Investment Corp. invests in a portfolio of residential mortgage-backed securities, mortgage servicing rights, and other related assets. As far as leverage goes, Two Harbors looks much more like a standard mortgage REIT than New York Mortgage Trust, with a leverage ratio of about 5 to 1. This is certainly higher than the other two on the list, but it's still below the industry average.

This is because the bulk of Two Harbors' portfolio (74%) is made up of agency mortgage-backed securities, which refer to mortgages backed by Fannie Mae, Freddie Mac, or Ginnie Mae. Another 20% is non-agency and commercial mortgages. Just 6% of the portfolio is made up of mortgage servicing rights and other investments. However, it's this part of the portfolio that serves as a hedge against rate fluctuations.

As far as risk goes, Two Harbors estimates that a 100-basis-point rise in interest rates would result in a 4.8% reduction in net interest income. This is significantly less interest rate risk than its peer group's average, but it's still an important thing to consider since interest rates are expected to continue to climb for the next few years.

A unique investment strategy among mortgage REITs

PennyMac Mortgage Investment Trust was formed in the wake of the financial crisis as a mortgage REIT focused on distressed mortgages. The idea was that since it could acquire these mortgages at a deep discount and achieve a superior yield, it wouldn't need to use much leverage to earn strong returns.

Since then, the company's focus has changed substantially. In fact, distressed mortgages make up just 29% of the total equity, and the company is planning to sell off even more. Specifically, PennyMac is in the process of transitioning to a portfolio of credit risk transfers and mortgage servicing rights, which combine to make up 59% of the portfolio and growing.

Credit risk transfer (CRT) securities are designed to shift some of the risk of loss on pools of mortgages from Fannie Mae and Freddie Mac to the private sector -- that is, companies like PennyMac. And mortgage servicing rights (MSR) are contractual agreements that give the acquirer the rights to service existing mortgages. In a nutshell, the result is a portfolio that only requires about 1.5-to-1 leverage to generate double-digit returns.

To be clear, lower leverage doesn't necessarily mean lower risk. For example, PennyMac's credit risk transfer investments are vulnerable to default risk, and its portfolio of distressed mortgages is obviously riskier than a portfolio of top-notch performing loans would be.