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A real estate investment trust, or REIT, is a special type of corporation. Its primary business is investing in real estate and related assets. To be classified as a REIT, a corporation needs to meet a few basic criteria. REITs must
- invest at least 75% of assets into real estate or related assets,
- derive at least 75% of their income from real estate sources,
- have at least 100 shareholders,
- be no more than 50% owned by five shareholders, and
- pay out at least 90% of their taxable income to shareholders as dividends.
If it meets these requirements and a few more, a REIT enjoys a nice tax advantage: It pays zero corporate tax on its profits. REITs are pass-through entities, similar in tax treatment to a partnership or LLC.
With most dividend-paying stocks, profits are effectively taxed twice. Once when they are earned (corporate tax), and again when they’re paid out to shareholders (dividend tax). REIT profits are only taxed on the individual level. And if they’re held in a tax-advantaged retirement account, investors don’t have to worry about paying taxes on their dividends at all.
What is a mortgage REIT?
When it comes to REITs, there are two main categories -- equity REITs and mortgage REITs (also known as mREITs). Equity REITs are what most people think of when they hear the term "real estate investment trust." These companies own, manage, and develop commercial properties.
Mortgage REITs invest in mortgages, mortgage-backed securities, and related assets. According to Nareit, mortgage REITs help finance 1.8 million homes in the United States. As you might imagine, this is quite a different business than owning properties. In fact, mortgage REITs aren’t even classified in the real estate sector -- they're considered financial stocks.
The mortgage REIT business is complex and REITs take different approaches. But in general, they use large amounts of debt to profit from the difference between the rates paid by mortgages and short-term borrowing rates.
If a mortgage REIT can borrow money at 3% interest to buy mortgages that pay 4.5% interest, the 1.5% difference is the profit margin. Most investors aren’t interested in a yield of 1.5%, so these companies use lots of borrowed money to maximize profits.
Let’s say that a mortgage REIT has $2 billion in investor capital. In addition to this amount, it borrows $10 billion at 3% interest to buy mortgages, which pay interest rates of 4.5% on average. This company would own $12 billion worth of mortgages paying a total of $540 million in interest annually (4.5% of $12 billion). The REIT would pay $300 million in interest on its debt for a total annual income of $240 million. This is a 12% return on the $2 billion in investor capital.
That's a very simple example. Several other factors determine mortgage REIT profits, and we’ll get into some of them in the next section. This simply illustrates why mortgage REITs tend to pay such high dividend yields.
It’s also important to mention that mortgage REITs are intended solely as income investments. In other words, mortgage REITs don’t invest in assets because they think they’ll go up in value. They're primarily focused on generating income.
Risks of investing in mortgage REITs
Individual business models vary, but interest rates are typically the biggest risk to investing in mortgage REITs.
These companies borrow money at lower short-term rates to buy mortgages, which generally have terms of 15 or 30 years. This works if short-term interest rates stay the same or drop. But if short-term borrowing rates go up, mortgage REITs’ profit margins can erode fast.
Using our example from the last section, we’ll say our hypothetical mortgage REIT borrowed money at 3% to buy mortgages paying 4.5%, giving a 1.5% profit margin. If the short-term borrowing rate rises to 4%, it cuts the profit margin to just 0.5%. If the short-term rate reaches 4.5%, the profit margin disappears completely. Any higher and the company is losing money.
This is a simplified version of what happens. In practice, mortgage REITs use several methods to protect against interest rate changes. Mortgage REITs use a variety of hedging strategies, such as interest rate swaps and other types of futures contracts, to reduce the impact of rising rates.
In addition, there are a few other risk factors mortgage REIT investors should know:
- Credit: There are two main categories of mortgages a mortgage REIT can invest in. Agency mortgages are backed by the federal government and have minimal default risk. Non-agency mortgages are only as safe as the borrowers they’re made out to. Most commercial loans fall into the latter category, so be aware of the risk if you invest in a mortgage REIT that invests in non-agency loans.
- Prepayment: If a mortgage REIT buys a 15-year mortgage, it wants to collect 15 years' worth of interest. But if interest rates fall, borrowers often refinance their mortgages. That leaves mortgage REITs with capital that must be reinvested at new, lower rates.
3 of the largest mortgage REITs
Here are three of the largest mortgage REITs in the market, followed by a brief description of each.
|Company (Stock Symbol)||Asset Type(s)||Market Capitalization||Dividend Yield|
|Annaly Capital Management (NYSE: NLY)||Agency mortgages (mostly)||$13.5 billion||12.4%|
|Two Harbors Investment (NYSE: TWO)||Agency, non-agency, commercial, and mortgage servicing rights (MSRs)||$3.7 billion||13.8%|
|Starwood Property Trust (NYSE: STWD)||Commercial mortgages||$6.5 billion||8.3%|
As the largest mortgage REIT in the market, Annaly Capital Management has a big portfolio. Over 90% of its assets are invested in agency mortgages, and it operates in residential credit, commercial real estate, and middle-market lending. Because of its size, Annaly enjoys cost advantages over competitors. Its operating expenses are well below its peer group average.
Two Harbors is significantly smaller than Annaly and has a similar mix of assets. However, about three-fourths of the portfolio is made up of agency mortgages, so Two Harbors has higher exposure to riskier non-agency loans. But these loans are also potentially more lucrative. Two Harbors does an excellent job of hedging against interest rate risks, so it has an interest rate sensitivity level well below average.
Finally, Starwood Property Trust is the largest mortgage REIT specializing in commercial mortgages. Its primary business is originating and owning floating-rate commercial mortgages. Commercial mortgages are not agency-backed, and therefore have higher default rates. But Starwood uses lower leverage rates than most other mortgage REITs. Plus, the floating-rate nature of its loans acts as a natural hedge against rising interest rates.
The bottom line: high income with high risk
If you’re a risk-tolerant investor looking for high income, mortgage REITs can be a smart addition to your portfolio. Just expect quite a bit of volatility over time, especially when interest rates are moving rapidly in one direction or the other.