Mortgage REITs, or mREITs, are a type of real estate investment trust (REIT) that invest in mortgages and mortgage-backed securities (MBS).
They earn income from the interest payments on these assets, and they distribute most of their profits to shareholders as dividends.
mREITs can be an attractive option for investors who are looking for high yields and exposure to the real estate market.
However, they also come with high risks of mortgage reits that can affect their performance and valuation.
In this article, we will explore the benefits and drawbacks of investing in mREITs, and how to evaluate their current and future prospects.
Benefits of Investing in mREITs
One of the main advantages of investing in mREITs is that they offer higher dividend yields than most other REITs and fixed-income investments.
This is because mREITs use leverage, or borrowed money, to buy more mortgages and MBS than their equity capital can support.
By doing so, they can amplify their returns and payouts to shareholders.
For example, as of August 23, 2023, the average dividend yield of the FTSE Nareit All REITs Index was 3.6%, while the average dividend yield of the FTSE Nareit Mortgage REITs Index was 8.9%.
This means that mREITs paid more than twice as much dividends as the overall REIT sector.
Another benefit of investing in mREITs is that they provide liquidity and credit to the real estate market.
By buying mortgages and MBS from lenders, mREITs help free up capital that can be used to originate more loans for homebuyers and businesses.
This can stimulate the demand and supply of real estate, and support the economic growth and recovery.
Moreover, investing in mREITs can offer diversification to a portfolio.
mREITs have different risk and return profiles than equity REITs, which own and operate physical properties.
mREITs are more sensitive to interest rate changes, while equity REITs are more affected by occupancy rates and rent growth.
By holding both types of REITs, investors can reduce their exposure to any single factor that can impact the real estate market.
Risks of Investing in mREITs
While mREITs have some appealing features, they also have some significant drawbacks that investors should be aware of.
One of the main risks of investing in mREITs is that they are vulnerable to interest rate fluctuations.
This is because mREITs borrow money at short-term rates to buy mortgages and MBS that pay interest at long-term rates.
They make money from the spread between these two rates, which is called the net interest margin.
However, when interest rates rise, the value of mortgages and MBS declines, as new loans pay higher interest rates.
This reduces the book value and net asset value (NAV) of mREITs, which can lead to stock price declines.
Also, when short-term rates increase faster than long-term rates, the net interest margin shrinks, which lowers the income and dividends of mREITs.
Another risk of investing in mREITs is that they are subject to prepayment risk.
This is the risk that borrowers pay off their mortgages earlier than expected, usually when interest rates fall.
When this happens, mREITs lose the future interest income from these loans, and they have to reinvest the proceeds in lower-yielding assets.
This can also reduce their income and dividends.
Furthermore, investing in mREITs involves credit risk.
This is the risk that borrowers default on their mortgages or MBS payments, resulting in losses for mREITs.
Credit risk can vary depending on the type and quality of mortgages and MBS that mREITs hold.
For example, residential mortgages backed by government agencies such as Fannie Mae or Freddie Mac have lower credit risk than non-agency or subprime mortgages.
Similarly, commercial mortgages secured by high-quality properties have lower credit risk than those backed by lower-quality or distressed properties.
How to Evaluate mREIT Performance?
Given the benefits and risks of investing in mREITs, how can investors decide whether it is a good time to invest in them?
One way to assess the performance and prospects of mREITs is to look at some key metrics and indicators, such as:
Dividend yield
This is the annual dividend per share divided by the share price. It measures how much income an investor can expect to receive from holding an mREIT.
A high dividend yield can indicate a high return potential, but it can also signal a high risk or a dividend cut.
Investors should compare the dividend yield of an mREIT with its peers and historical averages, and also consider its dividend coverage ratio, which is the ratio of earnings per share to dividends per share.
A dividend coverage ratio above 1 means that an mREIT can sustain its dividend payments from its earnings.
Price-to-book ratio
This is the share price divided by the book value per share. It measures how much an investor is paying for the net assets of an mREIT.
A low price-to-book ratio can indicate that an mREIT is undervalued, but it can also reflect a low-quality or impaired portfolio.
Investors should compare the price-to-book ratio of an mREIT with its peers and historical averages, and also consider its return on equity, which is the ratio of net income to book value.
A high return on equity means that an mREIT is generating a high profit from its net assets.
Net interest margin
This is the difference between the interest income and interest expense of an mREIT, divided by its average interest-earning assets.
It measures how much an mREIT is earning from its spread-based business.
A high net interest margin can indicate a high profitability potential, but it can also imply a high leverage or interest rate risk.
