What Is a Mortgage Real estate investment trusts (REITs)

Investing in real estate is no longer limited to owning physical assets. Real estate investment trusts (REITs) provide an opportunity for various investors to invest in the entire real estate sector without the burden of property ownership. By investing in REITs, investors gain access to properties that specialize in diverse areas, such as retail, residential, medical facilities, and office spaces. However, among the REITs, mortgage REITs tend to be more misunderstood and undervalued.

Despite the potential for growth in the relatively isolated industry, many investors tend to overlook mortgage REITs. To benefit from their potential, investors must understand who they are and invest wisely. The following guide aims to introduce new investors to these wealth accumulation tools, so they can take advantage of the best mortgage REITs available in today's market.

What is a mortgage reit (mREIT)?

The term "m" in mREIT stands for "mortgage," indicating that these REITs specialize in investing in the mortgage market. More specifically, mREITs purchase mortgage-backed securities in the secondary mortgage market.

After a bank lends money to a borrower to buy a house, the borrower sells the mortgage to a mortgage buyer, which may be an mREIT. Some mREITs focus solely on traditional mortgages backed by quasi-government organizations such as Fannie Mae, Freddie Mac, or Ginny Mae. These loans are considered low risk and have relatively low interest rates and income as they are federally guaranteed.

Other mREITs, known as non-agency mREITs, specialize in mortgages that are not backed by the government. This includes both residential and commercial mortgages, which tend to offer higher dividends due to the higher interest rates associated with the higher risk. Investors can purchase stocks of mortgage REITs, commercial mREITs, or mREITs that invest in both types of debt.

Mortgage reit vs. stock reit

REITs are broadly categorized into two types: mortgage and equity REITs. Mortgage REITs invest in mortgage-backed securities and other mortgage-related assets and are renowned for high dividends earned through interest income. They are relatively less common compared to equity REITs.

Equity REITs buy and manage rental properties, earning income through rental payments from tenants. They are known for providing stable income. Both mortgage and equity REITs are required to distribute at least 90% of their income to investors.

How mREITs work

Investors can purchase mREITs stock through a brokerage account, just like any other publicly listed stock. As co-owners of the company, shareholders receive dividends from mREITs, which tend to be high due to the income generated through interest income.

Since mortgage rates are linked to the Treasury bond market, changes in interest rates can also impact mREITs. Because they are required to pay out almost all of their profits as dividends, mREITs often have to borrow money to acquire more mortgages. As a result, they borrow at short-term bond rates and lend at higher long-term bond rates.

The profitability of mREITs is directly proportional to the gap or "spread" between short-term and long-term bond rates. The wider the spread between these rates, the more profitable the mREIT business.

Like any other publicly traded company, the value of mREITs can fluctuate during trading hours depending on market demand. If investors expect mREITs to be less profitable, their stock prices will decrease. Additionally, since many investors view mREITs as a passive source of income, any potential decline in dividends can also lead to a decrease in stock prices.

Should I invest in mREITs?

Mortgage REITs offer a potential stream of passive income and serve as an alternative to high-yield bonds, making them an appealing investment choice for retirees and older individuals preparing for retirement. However, compared to other real estate investments, government REITs may not be as desirable due to their tendency to diversify independently of stock values, which can negatively impact their value. Additionally, other types of real estate investments, such as real estate crowdfunding, direct real estate investments, and real estate investments, have shown higher returns.

Taxation is another consideration. Dividends from mortgage REITs are regarded as ordinary dividends, are not eligible for preferential tax treatment, and are subject to taxation at the shareholder's marginal rate. Therefore, the higher the tax rate, the less profitable it becomes.

However, if you hold your REIT assets in a tax-deferred retirement account while still working, the REIT dividends will not be fully included in your taxable income.

If you are a low- or middle-income retiree, adding mREITs to your investment portfolio can help diversify your sources of income. However, keep in mind that they come with a lot of volatility and risk, so it's best not to invest the majority of your portfolio here.

For younger individuals or those seeking higher returns, mREITs may appear attractive. However, better returns and tax treatment can frequently be found in other investment opportunities.

How do I invest in mortgage REITs?

Mortgage REITs offer investors an opportunity to participate in the profitable real estate industry without having to own physical real estate assets. By investing in companies that invest in real estate, investors can avoid the high costs associated with purchasing property in today's market. Additionally, the historical performance of the REIT sector has been impressive, with annual returns surpassing the S&P 500 Index for the majority of the time since 1972.

Investing in mortgage REITs is relatively simple, involving joining a broker, depositing funds, and purchasing stocks in listed mREITs. However, the key challenge lies in selecting the appropriate mortgage REIT for investment. As such, investors should conduct their own due diligence and undertake thorough research to determine which mREIT would best fit their portfolio.

Investors should evaluate the benefits and risks of mortgage REITs before making an investment decision. In doing so, they can better understand the opportunities and challenges associated with this investment option. Ultimately, careful consideration of these factors can aid in selecting a suitable mortgage REIT for investment.

Mortgage Reits Risk

it can negatively impact mortgage REITs. This is because their business model relies on charging interest, and lower interest rates can lead to reduced potential income. To mitigate this risk, investors should consider diversifying their portfolios with stocks that can generate returns in times of low interest rates, such as technology companies.

Individual Real Estate Risk: Mortgage REITs may lend on different types of real estate, which can result in varying levels of risk. As they try to diversify their portfolio, they may lend on real estate that poses higher risks. For instance, during the pandemic, retail storefronts located in small spaces suffered while stores deemed necessary, such as grocery stores, remained profitable and able to pay their mortgages. Therefore, investors should consider the credit risk associated with the types of real estate that mortgage REITs invest in before choosing to invest.

In summary, while REIT yields have been attractive over the years, investors should carefully consider the risks involved. This includes tax-related risks, the impact of interest rate volatility, and the individual real estate risks associated with mortgage REITs. By understanding these risks, investors can make informed decisions when investing in this asset class.