Image source: 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.

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. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at Thanks -- and Fool on!