Mortgage REIT's: Everything you Need to Know

Mortgage REIT's: Everything you Need to Know

REITs are Real Estate Investment Trusts. They are commercial real estate investment vehicles focused on real estate properties, and they regularly make distributions based on the income generated by these properties. Most REITs are producing income through leases, more so than by buying and selling residential and commercial properties, this helps produce a more stable income. An investment trust can be private, so accessible only to a subset of investors, or made public through the stock market, thus accessible to all. Public REITs are traded easily like a stock, which is an advantage. Their values will go up and down depending on the valuation of the owned properties, and expectations of future valuation from the stock market (potentially with a premium or a discount to NAV). REITs are required to distribute 90% of the taxable earnings as dividends. Some distribute up to 100% to not have to pay any corporate taxes or capital gains. The dividend yields from the distribution may influence the price of the public REITs as well. Because the dividends are non-qualified, REITs are better held in tax-advantaged accounts.

There are 4 main categories of the asset class of equity REITs (also called eREITs): Retail, Residential, Healthcare and Office. There is another kind of REIT which is Mortgage REITs (also called mREITs) that are built differently compared to equity REITs. We are going to talk more about Mortgage REITs here, but you can find more details on the other types of REIT in this blog entry [Add link here].

Unlike equity REITs (i.e most REITs) that invest in properties and distribute the income from the leases, Mortgage REITs (mREITs) generate the income from the interest of their commercial mortgages and residential mortgage investments. They lend the money with long term loans and high interest rate, and finance this operation by borrowing money with short term loans and lower interest rate. They make money with the spread between the cost of borrowing and the loan they make. To limit the credit risk, mREITs lend the money by buying Mortgage Backed Securities (or MBS), which are backed by the federal government. Like eREITs, there are multiple categories of mREITs, with different risks.

In general, due to their very high leverage, mREITs perform very poorly during financial crises, and much better during stable periods. Because their profit is based on the interest spread, they do better when interest rates rise rather than when they are low. eREITs have a combination of income and growth, and are more conservative than mREITs. The NAV of mREITs can vary quite a bit there won’t be much long term capital appreciation, but they will provide the best income. In some cases though, this income can be just a return of capital.

One of the biggest mREIT ETFs is REM. As of early 2021, REM offers a yield of around 7% and has an expense ratio of 0.48% per year. It is worth noting that REM NAV is below its inception NAV of May 2007 (-23% in total returns, almost 14 years later), even when including reinvested dividends. REM cratered during the great recession of 2008 (-73%), and almost recovered by February 2020, before cratering again in March-April 2020 (-69%). REM went up quite a bit afterwards. mREITs are to be used by risk-tolerant individual investors during a recovery.

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