Mortgage REITs, or mREITs, provide real estate financing by originating or purchasing mortgages or mortgage-backed securities. They are an essential part of the residential mortgage market, helping to finance roughly 1.7 million homes each year. They also support the commercial real estate sector by providing loans to develop, acquire, reposition, and own income-producing properties.
Here's a closer look at the overall mortgage REIT market, the sector's unique risks, and some interesting mREITs to consider.
Understanding mortgage REITs
Mortgage REITs are a subcategory of the real estate investment trust (REIT) segment that focuses on providing real estate financing. The entities purchase or originate mortgages and mortgage-backed securities, earning interest income from their investments. Some mREITs also earn loan origination and servicing fees. These factors make mREITs similar to financial stocks.
Mortgage REITs make money differently than other real estate investments. They earn a profit on their net interest margin, which is the spread between the interest income generated by their mortgage assets and their funding costs. Mortgage REITs use various funding sources to originate and purchase mortgages and related securities, including common and preferred equity, repurchase agreements, structured financing, convertible and long-term debt, and credit facilities.
mREITs use those funding sources to acquire mortgage-related assets. Some mREITs will originate loans they hold on their balance sheet and sell them to other buyers, including government agencies, banks, or investors. In addition, mREITs purchase mortgages and mortgage-backed securities. They collect the fees and loan interest generated by mortgages, keeping what remains after paying funding and operating expenses.
Here's an example of how mREITs work. Let's say an mREIT raises $100 million of equity from investors to buy mortgages. It secures another $400 million from other sources, at an average funding cost of 2%, allowing it to purchase $500 million of mortgage-backed securities.
If the loans had an average weighted yield of 3%, they would generate $15 million of interest income annually. Meanwhile, at a 2% cost of funding, it would have $8 million of annual funding costs, allowing the mREIT to generate $7 million of net interest margin each year.
Risks of investing in mortgage REITs
Mortgage REITs are riskier than many other investments, including other REITs, because they face certain specific risks, including:
- Interest rate risk: While changes in interest rates affect REITs overall, they have an even greater effect on mREITs because changes in short- and long-term interest rates can affect net interest margins by increasing the costs of funding and reducing interest income. Interest rate changes can also affect the value of an mREIT's mortgage assets, affecting its net asset value and share price.
- Prepayment risk: Mortgage borrowers can refinance their loans or sell the underlying real estate. When that happens, it forces the mREIT to reinvest the repaid loan proceeds in the current interest rate market, which might be lower than the rate on the existing mortgage.
- Credit risk: mREITs focused on commercial mortgages can face credit risks if borrowers default.
- Rollover risk: Residential mortgage REITs tend to own long-term mortgages and mortgage-backed securities. However, they often fund these purchases with shorter-duration borrowing since short-term interest rates are generally lower than long-term rates. This funding strategy creates rollover risk. The mREIT must obtain funding at attractive rates to roll over loans as they mature.
3 mortgage REITs to consider in 2022
There are almost two dozen mREITs focused on home financing and another 18 focused on the commercial mortgage sector. Most have underperformed the S&P 500 in recent years due to fluctuating interest rates. However, a few mREITs stand out as strong performers in this volatile sector:
|Top Mortgage REITs||Ticker||Type of Assets||Market Cap||Dividend Yield|
|Arbor Realty Trust||(NYSE:ABR)||Commercial||$2.7 billion||7.3%|
|Hannon Armstrong Sustainable Infrastructure Capital||(NYSE:HASI)||Commercial||$4.6 billion||2.4%|
Here's a closer look at the leading mortgage REITs.
Arbor Realty Trust
Arbor Realty Trust is an mREIT that finances commercial real estate. It focuses on making loans backed by multifamily properties, although it also finances student housing, land, healthcare facilities, offices, single-family rentals, and other property types.
The real estate financing company has three business platforms:
- Balance sheet loan origination: Arbor underwrites loans that it holds on its balance sheet.
- Government-Sponsored Enterprise (GSE)/Agency loan origination: The REIT originates small-balance loans ($1 million to $8 million) that it sells to Fannie Mae, Freddie Mac, the Federal Housing Administration, and other agencies.
- Servicing: Arbor provides servicing on multifamily loans primarily held by GSEs.
Arbor's business model provides it with multiple income streams. The mREIT produces recurring long-dated cash flow from servicing fees, escrow revenue, and net interest income. It also generates one-time origination fees. This strategy gives it an advantage over mREITs focused solely on making money via the net interest margin.
Its diversified operating platform and multifamily focus have enabled it to generate fairly steady earnings in all market cycles. Arbor delivered its ninth consecutive annual dividend increase in 2021. That's notable since mREIT dividends have historically fluctuated because of the impact interest rates have on their net interest margin.
Hannon Armstrong Sustainable Infrastructure Capital
Hannon Armstrong is a unique mREIT. It's the first U.S. public company solely focused on investing in climate solutions by providing capital to companies in energy efficiency, renewable energy, and other sustainable infrastructure markets.
Hannon Armstrong generates both investment and fee income. It uses investor capital and other funding sources to make debt and preferred equity investments in a range of climate-positive companies and projects. It makes these investments on its balance sheet. Its investment portfolio generates a net investment margin for the company as long as the gross yield on the assets exceeds its interest expenses. The company also generates fee income from securitizing investments and advising clients.
The company's climate-focused financing strategy has been highly successful. Hannon Armstrong has paid a stable and growing dividend and generated market-beating total returns in recent years. Its growth should continue because the company has a large pipeline of investment opportunities due to the accelerating shift toward sustainability. The trend leads Hannon to estimate it can increase its distributable earnings per share at a 7% to 10% annual rate through 2023 while boosting its dividend per share at a 3% to 5% yearly pace.
iStar has taken an innovative approach to financing commercial real estate over the years. It helped pioneer the adoption of using mezzanine capital to finance real estate investments in the 1990s. In the 2000s, iStar started focusing on improving the net lease market. More recently, the company has shifted its focus to ground leases. It created specialty REIT Safehold (NYSE:SAFE) to drive this strategy and is currently Safehold's investment manager and largest shareholder.
A ground lease, as the name suggests, is a lease on the ground underneath a structure. Through Safehold, iStar provides financing to commercial real estate developers and owners by acquiring the land underneath a building and leasing it back, providing it with very stable income.
In addition to its investment in Safehold, iStar still holds investments in its legacy financing strategies. However, it's slowing winding down those businesses. As Safehold has grown as a percentage of iStar's portfolio (it was 39% in late 2021), its legacy loan portfolio has declined, falling from 14% in 2020 to 11% in 2021. Meanwhile, iStar is exploring the sale of its net lease assets, which made up 36% of its portfolio.
iStar's focus on expanding its ground lease business through Safehold has paid off. The company's equity value per share has steadily risen as Safehold has grown. That strategy has also enabled iStar to steadily increase its dividend. It benefits from the growing cash flows produced by managing and owning Safehold, as well as those produced by its legacy business lines.
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Mortgage REITs offer higher dividends along with higher risk
mREITs can generate a significant net interest margin when there's a wide spread between short-term interest rates (where they borrow) and long-term interest rates (where they lend). Unfortunately, the spread doesn't usually stay wide for long, which is why mREITs tend to be very volatile. Because of that risk, mREIT's aren't always the best option for income-seeking investors since their high yields fluctuate wildly. However, a few interesting mREITs are worth considering as their differentiated business models help insulate them from the sector's overall volatility.