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The Short Answer

Getting a Read on Mortgage REITs

This high-income vehicle warrants close scrutiny given interest-rate uncertainty.

Question: I've heard that mortgage REITs can be a good way to get extra income. What are the pros and cons of investing in one?

Answer: Mortgage REITs have exploded in popularity in recent years, in part because their yields can be attractive. But as with any high-yielding instrument, there’s no such thing as a free lunch. Unless interest-rate conditions are just right, mortgage REITs can run into trouble.

Mortgage REITs (real estate investment trusts) are similar in nature to equity REITs, but with some key differences. Whereas equity REITs invest in commercial or residential properties, passing along to shareholders much of the income they receive, mortgage REITs invest only in commercial or residential mortgages and mortgage-backed securities. The interest payments made on these mortgages generates income for the REIT and, thus, for its shareholders.

Mortgage REITs use their equity or take out loans of their own--often at short-term rates--to initiate or buy mortgages as part of a leveraged strategy. The amount of interest the REIT earns on the mortgage minus its cost to fund or obtain the mortgage becomes the REIT's profit. For example, if the REIT owns a mortgage that requires the borrower to pay 4% interest over 30 years but the REIT can borrow the money to fund the mortgage at a short-term rate of 1%, the REIT banks a profit on this 3-percentage-point difference. Mortgage REITs typically use leverage (additional borrowing) to amplify this spread.  

An Income-Generating Vehicle
As with all REITs, mortgage REITs are required by law to pass along most of their income to shareholders, and therein lies their appeal for income-oriented investors: Mortgage REITs offer some of the highest yields of any security type, some in excess of 10%. (It's also worth noting that while REITs don't pay taxes on the dividends they pass along to shareholders, the shareholders themselves must pay them and at ordinary income tax rates rather than at the lower rates applied to qualified dividends.)

In addition to generating income, mortgage REITs can be used to help diversify a portfolio. While REITs in general have become more highly correlated to stocks in recent years due partly to their inclusion in some widely tracked equity indexes, mortgage REITs are more loosely correlated to stocks than equity REITs are.

Some mortgage REITs trade on exchanges like stocks. At the end of 2013, there were 45 listed mortgage REITs on the New York Stock Exchange and NASDAQ with a total market capitalization of $62 billion, according to figures from the National Association of Real Estate Investment Trusts.

ETFs that invest exclusively in mortgage REITs include  iShares Mortgage Real Estate Capped ETF (REM), an index-based fund that yielded 13.7% on average over the past year, and Market Vectors Mortgage REIT Income ETF (MORT), which yielded 12.6%. (By contrast,  Vanguard REIT ETF (VNQ), our analysts' pick for ETF exposure to equity REITs and which excludes mortgage REITs, yielded just 3.1%.)

Now for the Warning Label
Before you rush off to buy mortgage REITs or mortgage REIT funds to get a piece of those juicy yields, make sure you understand the risks that come with them. In particular, mortgage REITs are highly subject to interest-rate risk. For example, as short-term interest rates rise, the REIT may have to pay more to borrow money, potentially reducing the spread between its borrowing costs and the income it receives from the mortgages it owns--thus, reducing its profit (and shareholder dividends). Generally, the more leveraged the mortgage REIT (that is, the more borrowing it does), the greater the potential to feel the squeeze when rates rise. At the same time, if long-term rates rise faster than short-term rates, this increases the spread and the REIT's profit may increase. However, rising long-term rates also could hurt the value of existing mortgages already in the REIT's portfolio, thus, hurting the REIT’s value.

Mortgage REITs typically try to account for various potential short-term scenarios by using hedging strategies based on derivatives such as interest-rate swaps. But their high degree of interest-rate sensitivity generally makes mortgage-REIT yields more volatile than those paid out by equity REITs or stocks.

The Best of Times--But for How Long?
In recent years, mortgage REITs have flourished amid historically low interest rates. However, during periods when rates have risen--or when fears of rising rates have taken hold--mortgage REITs have taken a beating. IShares Mortgage Real Estate Capped ETF's two biggest holdings--Annaly Capital Management (NLY) and American Capital Agency (AGNC)--lost 18.3% and 20.3%, respectively, in 2013, as worries about the end of the Fed's bond-buying stimulus program sent interest rates higher. As rates have drifted lower again this year these REITs have rebounded, with Annaly Capital Management up 24.1% and American Capital Agency up 27.8% as of Aug. 22.

Another potential interest rate-related pitfall for mortgage REITs is prepayment  risk--the chances that borrowers will prepay mortgages in order to refinance at lower rates. In such cases, the mortgage REIT no longer receives interest payments at the higher rate and may have to settle for buying mortgages that pay lower rates. While prepayment risk has been a real concern in this era of historically low mortgage rates, it is less likely to be an issue should they continue to rise.

Most residential mortgage REITs are backed by the federal agencies Fannie Mae and Freddie Mac, which minimizes the credit risk associated with them. However, commercial mortgage REITs lack this protection and may carry some credit risk.

While no one knows for sure if or when interest rates will increase in the coming years, most investors seem to expect they will. How this will affect the performance of mortgage REITs is anyone's guess, but the fact that there is so much uncertainty should give any investor pause.

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Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.