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How to Find the Best Mortgage REITs

Jun 19, 2020 by Kevin Vandenboss

Mortgage REITs have quite a different model than your typical equity REIT. Instead of investing in physical properties, they invest in loans secured by real estate. A mortgage REIT will typically buy mortgages in portfolios. Some are brand new mortgages, while others may be seasoned, meaning they have an established payment history already.

Instead of taking out long-term debt to purchase a real estate asset to collect rent, a mortgage REIT uses short-term debt at a low interest rate to finance their book of mortgage loans. Their profit comes from earning more interest on the loan than the interest they're paying on their debt.

Since these types of REITs have a unique business model compared to other REITs, and even other stocks, there are other metrics you'll want to consider when choosing a mortgage REIT to invest in.

Should you invest in mortgage REITs?

Many investors are attracted to mREITs because of their ultra-high dividend yields. Most mortgage REITs have a dividend yield of 10% or more. Many even have yields of 20%-30%. Yields like this are hard to ignore and pique just about anyone's interest.

Of course, these high-dividend yields come at the price of being one of the higher-risk investments available. Even the most stable mREITs have a higher risk profile than most equity REITs.

Interest rates have a major impact on mREITs and how well they perform from one quarter to the next. Mortgage REITs are highly leveraged using short-term debt. Since the mortgages they invest in can have terms of 15-30 years, they are in a constant cycle of taking on new debt to pay for the old. If interest rates on their short-term debt rise, their spreads get squeezed.

Since a mortgage REIT's earnings come from the spread between the interest they pay on their debt and the interest they receive on their mortgage investments, the fluctuations in the spread cause a lot of fluctuations in their earnings and dividend payouts. These fluctuations, in turn, cause volatility in their share price.

Mortgage REITs are not ideal for investors with a low-to-medium risk tolerance or anyone looking for a long-term investment they can let grow over time without monitoring closely.

What to look for in a mortgage REIT

Every investor has their preferred metrics to look at when picking stocks, but the most important thing to look at is the REIT's management and how well they have handled their debt and changes in interest rates in the past.

One of the best ways to track this is by looking at the REIT's book value per share over time. Since an mREIT has to constantly raise capital to grow, either through debt or equity, by carefully evaluating this metric you can see how well the management has been doing at choosing the right strategies as they maneuver through different market conditions.

One of the other important things to look at is the REIT's EPS payout ratio. Most of the things you've read about REITs probably says EPS payout ratios don't paint an accurate picture due to the differences in actual earnings vs. taxable earnings. However, mREITs don't get to follow the same tax strategy as equity REITs.

Since mortgage REITs have an incredibly high dividend yield, you'll want to see how sustainable that dividend is. The share price in an mREIT can drop quickly if they announce any dividend cuts.

The bottom line

Mortgage REITs probably aren't the best playground for inexperienced investors or anyone without a high risk tolerance. There's money to be made in these REITs, but they require a lot of attention and careful monitoring. With the uncertain economy we're facing now, it's probably best to hold off on putting your money into this kind of investment for the time being.

If you decide to invest in a mortgage REIT, do a lot of due diligence before making an investment, and be fully aware of the risk you're taking on. Obviously people have success in mREIT investing, otherwise their shares wouldn't be traded. Just be prepared to babysit your investment.

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