Over the past decade, as interest rates have essentially been pegged near zero, income-hungry investors have been attracted to higher-yielding equity classes such as: Master Limited Partnerships, Business Development Companies, and Real Estate Investment Trusts.

One class of REITs in particular, mortgage REITs, has been especially popular thanks to its sky-high dividends, which often yield as much as 10% to 15% and sometimes pay out monthly.

However, of all the various high-yield pass through equity classes, in which the company doesn’t pay taxes as long as it distributes almost all taxable net income to investors, mortgage REITs are by far the hardest to invest in successfully.

Let’s take a look at why this equity class, while potentially alluring for some high-risk, hands-on investors, is also the riskiest way to reach for ultra-high-yields in this time of historically low interest rates.

What are Mortgage REITs?

Both equity REITs, or eREITs (which own properties and generate cash flow from rent), and mortgage REITs, or mREITs, were created in 1960 by Congress. The goal was to create: “greater diversification of investment,” “expert investment counsel,” and the means of “collectively financing projects which the investors could not undertake singly.”

In other words, to create a class of equities that could easily raise money from investors to help finance real estate investment, both residential and commercial. And like eREITs, which is what most dividend investors are familiar with, mortgage REITs also are legally required to pay out a minimum of 90% of profits as non-qualified dividends, in order to avoid paying taxes at a company level.

However, the difference between the two types of REITs is in their business models, which are as different as night and day. eREITs function as aggregators of properties, and mostly generate cash flow through collecting rent. mREITs on the other hand, usually own no actual properties but merely function as a type of closed-end, private equity fund (investors can only sell shares, not take money out of the fund).

Specifically, mREITs raise both debt (lower rate, short-term loans) and equity (via new share issuances) capital to buy longer-term and higher interest rate real estate debt and related securities. The difference, or spread, between the cost of borrowing and lending is how they earn their profits, and what ultimately supports the dividend.

In other words, mortgage REITs function as a less regulated, riskier kind of bank, aggregating cheap capital and then indirectly lending it out at higher interest rates by purchasing mortgage backed securities.

Different Kinds of mREITs

Like eREITs, there are several kinds of mREITs that one can invest in. The two biggest distinctions are: residential vs. commercial focus, and internal vs. external management.

Internal management simply means that the managers of the REIT’s assets work for the company itself. Thus their compensation is more transparent and theoretically able to be altered by shareholders via the board of director’s compensation committee.

External management means that the management comes from a third party, usually a large asset manager, who doesn’t have to disclose how much management is paid. Externally managed mREITs pay a base management fee, which is usually a percentage of assets, as well as performance fees based on the growth of book value.

Or to put it another way, externally managed mREITs are essentially private equity funds specializing in real estate based financial instruments.

The other major distinction between mortgage REITs is whether they focus on residential or commercial real estate.

Residential mREITs, such as Annaly Capital Management (NLY) and American Capital Agency (AGNC), make almost all their money by buying low credit risk (i.e. “agency backed”) home mortgage backed securities, or MBS, that are insured against default by Fannie Mae (FNMA), Freddie Mac (FMCC), or Ginnie Mae.

Because these are essentially government backed securities, with virtually no default risk, the yield on these MBS are low, requiring higher leverage by the mREIT, typically around 6-8:1 (i.e. borrow $6 to $8 for every $1 of equity invested).

Commercial mortgage REITs such as Starwood Property Trust (STWD), on the other hand, operate by investing or originating commercial mortgages, which have no government backing and are therefore higher risk. However, because of this, they are higher-yielding loans, which means that commercial mREITs usually operate with far lower leverage levels.

Also, commercial real estate is usually more stable than residential real estate, meaning that, assuming strong underwriting or due diligence (i.e. research into the mortgages backing the security), the default risk can be lower than that of residential mortgages.

Of course, the differences between residential and commercial mREITs also apply to the risks faced by both, which is the most important thing for potential or current investors to understand.

Key Risks to Owning mREITs

Because mREITs are highly specialized financial companies, understanding both their business models and risks are absolutely vital to long-term investing success.

Mortgage REITs

Source: Brad Thomas
For example, residential mREITs, because most of their business is agency backed MBS, have little principle (i.e. default) risk since they are backed by the government. However, as explained earlier, the lower yield on these types of securities means that residential mREITs need to take on higher leverage and hedge against changes in interest rates via derivatives such as interest rate swaps and swaptions.

In addition, because home mortgage rates have been falling over time there is a higher risk of prepayment. This is when the homeowner refinances and pays off the original mortgage in exchange for a new mortgage with a lower interest rate, and thus a lower monthly cost.

The reason this is bad for residential mortgage REITs is because they usually buy these MBS on the open market at around 4% to 6% above par value (i.e. the value of the underlying principle mortgage loan).

This means they rely on the mortgage holder paying off the loan over the full 15 to 30 year duration of the mortgage, so that interest payments can allow them to amortize the premium they paid for the security. If a loan is refinanced and paid off early, this can mean a loss for the mREIT, which hurts both book value (the intrinsic value of the company) and EPS that funds the dividend.

Commercial MBS, on the other hand, usually have lower prepayment risk but higher credit risk, and thus come with higher-yields that allow the mREIT to utilize lower leverage and less interest rate hedging.

In addition, commercial mortgages are usually floating rate loans, meaning tied to the LIBOR, or London Interbank Offered Rate. In other words, while most residential MBS are fixed-rate, the interest rate on commercial MBS rises with interest rates, allowing commercial mortgage REITs to potentially profit from a rising interest rate environment.

This distinction is important because residential mortgages, usually being fixed, fall in value with rising interest rates, which negatively affects the value of a residential mREITs loan book (i.e. book value, or net asset value per share). And since the share price generally follows the trend in book value, residential mREITs generally thrive in a falling interest rate environment, but suffer if rates rise.

Here is a look at Annaly Capital’s sensitivity to interest rates. Note that a 0.75% increase in interest rates is expected to reduce the company’s net asset value by 6.6%.