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What Is a Mortgage REIT (mREIT) – Definition, Risks & Suitability

By Michael Foster

Publicly traded REITs (real estate investment trusts) have attracted growing investor interest lately, thanks to their high dividends. While a large cap stock rarely pays a dividend yield above 5%, it is not uncommon for REITs to pay dividend yields of 10% or higher. In 2011, some REITs were paying dividends over 15%, and for the first half of 2012, many of these companies’ stocks also rose over 10%.

Recently, there has been growing interest in a class of REITs called mREITs, which also pay high dividends but pose a slightly different set of risks.

What Is an mREIT?

The “m” stands for “mortgage,” as mREITs are a special group of REITs that base their real estate investments in the mortgage market. For the most part, this means that mREITs buy mortgages on the secondary mortgage market – in other words, they purchase mortgage debts.

After a bank lends money to someone buying a house, the bank sells that mortgage to a mortgage buyer (such as an mREIT), and since mortgage rates are tied to the government bond market, mREITs are closely tied to that market as well.

Types of mREITs

When an mREIT is established, it usually specializes in one type of mortgage debt. Some companies only buy mortgages that are backed by a federal agency like Fannie Mae, Freddie Mac, or Ginnie Mae. They choose these mortgages because they are backed by a federal guarantee and thus there is a lower risk of default, which means that they are also less profitable.

Other mREITs, sometimes called non-agency mREITs, specialize in mortgages that are not guaranteed by a federal agency. These tend to pay higher dividends, largely because there is a higher risk of the mortgages being defaulted upon.

Owning Shares

Investors can buy into these mREITs by buying shares in the companies, which are publicly traded on a stock exchange. As a partial owner in the company, shareholders receive dividends from the mREITs – and that is where those attractive high yields come in.

Like other public companies, an mREIT goes up and down in value as the market reevaluates the company’s value. If investors believe that an mREIT will become less profitable because it becomes more expensive for them to raise money or because mortgages will underperform, the share price will go down. Since many investors look at mREITs as a source of passive income thanks to those high dividends, mREIT shares will also depreciate if investors think that dividends will go down.

Taxation

Though high dividend yields can be attractive, mREIT dividends should not be taken at face value. This is because mREIT comapanies must pay at least 90% of their income to shareholders by law, which in turn means that income is not taxed to the REIT, but is instead taxed as ordinary income to the shareholder. So mREIT dividends are not considered qualified dividends eligible for preferred tax treatment, but are considered ordinary dividends and are taxed at the shareholder’s marginal tax rate. Therefore, the higher your tax rate is, the less you stand to profit.

Because REITs are taxed at the ordinary income rate and not at the lower dividend rate , they can be a very inefficient way to earn passive income from a tax perspective. For some people, this is irrelevant, but if the income from a REIT investment moves the investor into a higher income tax bracket or they are already in one, it would probably be wiser for the investor to choose the lower yields of dividend-yielding stocks that are taxed at the lower dividend rate.

There is one way to avoid the tax penalty of REIT dividends: Keep REIT holdings in a tax-deferred retirement account to avoid having those REIT dividends added to your taxable income entirely while you’re still working.

mREITs and Bonds

One major factor that impacts mREITs’ profitability and dividend yield is change in the bond market. mREITs do not only buy mortgages with reinvested profits from the company’s activities. In fact, since so much of the company’s profits goes to investors, the company needs to borrow money in order to purchase mortgages.

This is where the bond market becomes crucial to an mREIT’s operations. Simply put, mREITs borrow money at short-term bond interest rates and lend it at rates near the higher long-term bond rates – when they buy mortgages, they’re essentially lending that money at current mortgage rates. Since mortgage rates are tied to the higher, long-term bond rates, mREIT profits are directly proportional to the gap (or “spread”) between short-term and long-term bond rates.

Since mortgage rates are tied to bond rates, an investor in mREITs needs to look at the bond market as well as the real estate and mortgage markets to understand that profit potential. The larger the gap, between short-term and long-term bond rates, the more profitable the mREIT business becomes. If the Federal Reserve keeps its promise to keep interest rates low, bond spreads should remain big, and mREIT dividends should remain high.

The biggest threat to mREITs is an increase in the short-term Treasury yield. This is partly why mREITs have become popular throughout 2012. In January, Chairman Ben Bernanke announced the Fed’s intention to keep rates low until the end of 2014, essentially guaranteeing mREITs’ profit margins for three years. The promise to continue injecting cash as part of QE3 in September also caused mREIT stock prices to jump further, as did Bernanke’s statement that the Federal Reserve plans to keep rates low until 2015.

Risks & Pitfalls for mREIT Investors

Before you run out and fill your portfolio with a bunch of mREITs, there are multiple points to consider. Though the profit potential can be high, mREIT investors risk losing money in the underlying share price and also via reduced dividends.

1. Dividend Cuts
A number of mREITs have cut their dividend payouts in recent years. There are many possible reasons for this: non-performing loans, bad management, and shrinking opportunities in the secondary mortgage market. And since mREIT dividends are very sensitive to fluctuations in the bond interest rates and to the amount of cash in the economy, if the Federal Reserve decides to raise interest rates, mREITs would be the first to lose value.

2. Mortgage Default and Refinancing
A higher borrowing cost would affect all mREITs, but individual mREITs can also be hurt by poor performing loans. If the mortgages held by an mREIT are defaulted upon, the mREIT loses money. While mREITs are usually highly diversified amongst different mortgages, they are still limited to one market and thus lack the diversity to withstand a collapse in the mortgage market.

If another calamity like the sub-prime mortgage crisis causes mortgage holders to default on their mortgages, it could devastate the mREIT market. There is one way to mitigate this risk, though: Some mREITs invest only in agency-backed mortgages, like Fannie Mae and Freddie Mac loans. Since these agency loans have a U.S. government guarantee, they are lower risk than non-agency mREITs, and usually offer a lower dividend yield as a result.

The other extreme, however, is just as bad: If a mortgage is paid off early, the mREIT also loses money because it will no longer get paid interest from that debt, and will have to purchase new debt. The high rate of mortgage refinances in 2012 has hurt some mREITs, and even though they can still borrow money at low rates and purchase mortgages, these mortgages are likely to have lower rates.

3. Operating Losses
Thirdly and most worryingly, many of the largest mREITs operate at a tiny profit or a loss. If an mREIT continues to operate at a profit smaller than the amount it must dole out for dividends, that dividend will have to be reduced. When these dividend reductions are announced, the mREIT’s share price usually falls as well. Of course, if the company operates at a loss for long enough, it will go out of business and the shares will be worthless.

In the second quarter of 2012, some of the largest mREITs by market capitalization reported losses of millions of dollars and operating margins of -30% to -60%. This is because long-term bond rates fell, narrowing the spread between short-term and long-term bond rates as investors looked for a safe bond market.

Since no company can operate forever at a loss, these disappointing returns raise uncomfortable questions about the sustainability of mREIT appreciation if bond spreads continue to narrow. It also brings up the question of just how much speculation and risk is in the mREIT market, since these losses were hitting companies just when their stock prices were soaring.

4. QE3 and Prepayment Risk
The Federal Reserve’s recent decision to initiate a third round of quantitative easing (QE3) is another concern for mREITs. QE3, unlike its predecessors, is being targeted at mortgage-backed securities – the Fed is planning on buying an unlimited amount of these securities monthly until the economy looks better.

These securities are the same ones that mREITs invest in, so this announcement affects them directly. With the Federal Reserve a more aggressive player in the market, there may be more opportunities for mortgage holders to refinance. This is bad for mREITs, because a refinance means that the mortgage they hold is paid off early – and the income they were earning from interest payments stop.

On the other hand, QE3 may have a more positive impact on the secondary mortgage market. By encouraging more refinances, it creates greater mortgage activity and thus more business opportunities for mREITs. Since it also keeps short-term bond rates low, a large spread between short-term and long-term bond rates should remain in place, allowing mREITs the opportunity to borrow money at a much lower rate than what they lend out.

5. Limited Capital
Since these companies need to return 90% of their income to shareholders, they are severely limited in how they can manage and reinvest their profits, which makes it hard to grow in good times and stay afloat in bad times. This makes the REIT structure an inherently risky business. The tradeoff for this risk is a much higher short-term dividend yield, but that tradeoff is not always sustainable.

Suitability

Since mREITs are volatile and easily impacted by the mortgage market, the real estate market, and the federal government bond market, they are a risky bet. However, their high yields and direct payment of profits to investors makes them a great source of cash in the short term.

Furthermore, they offer a liquid form of real estate investing and access to professional management. By purchasing shares in an mREIT, individual investors can indirectly lend money to people on the mortgage market. If you think there will be a recovery in the real estate and mortgage markets, mREITs are one way to make that bet.

Younger, more aggressive investors who do not own any real estate themselves but who are bullish on real estate might want to consider mREITs. However, mREITs can also have a place in more mature portfolios as long as the percentage they make up is no more than the investor can afford to take a loss on.

Final Word

The pitfalls in mREITs do not mean that they should always be avoided. By taking advantage of bond spreads that are fairly predictable and offering liquidity to the real estate market, mREITS provide a valuable service and an opportunity for investors to hand over their funds to experts who can play both the bond and real estate markets to turn a profit.

Before investing, though, look beyond those double-digit dividend yields, no matter how tantalizing they first appear. By looking at an mREIT’s balance sheet, cash flow statements, and past performance, investors can get a good sense of whether the company is worth investing in, and whether they can stomach the risk.

What are your thoughts on investing in mREITS?

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