Mortgage real estate investment trusts (REITs) are like the risky stepchild in the world of REITs -- often overlooked and outshined by safer dividend-paying equity REITs. Unlike equity REITs, which own and lease physical real estate, mortgage REITs invest and originate real estate debt and securities. This unique investment strategy means investors can still earn dividend returns, but not without some notable risks to consider. Here's a closer look at how mortgage REITs work and whether they are a good buy right now.
Image source: Getty Images
How mortgage REITs work
Mortgage REITs (or mREITs) either create commercial or residential mortgages, invest in real estate debt securities like mortgage-backed securities (MBS), or use a combination of the two. mREITs earn income from the interest paid on the mortgages over time and from net interest margin, which is the spread between the purchase price of any securities and the interest paid.
To grow, mortgage REITs either need to originate or buy more debt; create a higher net interest spread, which can happen by lowering acquisition costs or with higher interest rates; or expand their services, which can include servicing fees for servicing the loans.
Some years, like in 2021, origination demand is booming, making it easy to grow. In other years, mREITs have to leverage their existing debt to purchase more.
This can be a risky venture as factors like interest rates or a potential rise in mortgage delinquencies or early payoffs impact how much the company actually collects.
The lower the interest rate, the thinner the net margin spread, which translates to mREITs needing more volume to achieve the same profits. An increase in delinquencies means the company is collecting less, which could leave them unable to pay their debt obligations since they use that debt to leverage other debt acquisitions.
Image source: Getty Images.
As mortgage demand booms, is now a good time to invest?
While the pandemic hit a number of equity REITs hard, it did wonders for mortgage REITs. Thanks to historically low interest rates, record demand caused a surge in refinancing and a boom in home originations, helping mortgage REITs grow with very little effort. The challenge, however, is that historically low interest rates also meant there was a huge number of prepayments from borrowers refinancing.
If the mREIT originally held a 30-year mortgage at 5% interest and the borrower refinances with the same company, but at 3.5%, that's a huge loss in spread even if the amount owed increases because there is more equity in the property.
The Fed has indicated that they will increase interest rates in 2022, which will help mREITs earn more but could also cause a decrease in origination demand, offsetting potential gains and forcing the sector to find alternative ways to drive growth.
In 2021, the mortgage REIT index -- as tracked by the National Association of Real Estate Investment Trusts (NAREIT), which is comprised of 34 publicly traded mortgage REITs -- provided just over a 15% return for the full year. Not a bad return by any means, but it is nowhere near the performances of the S&P 500 or the NAREIT Equity REIT index, which provided a 43% return in 2021.
Historically, mortgage REITs underperform their equity REIT counterparts. But most people aren't looking to mREITs for their share price growth potential but rather their dividend return. The dividend yield for the NAREIT mortgage REIT index in 2021 was just over 9%, while equity REITs were just under 3%.
For example, Starwood Property Trust (STWD -2.13%), one of the highest-performing mREITs of 2021, currently offers a 7% dividend yield to investors, which is as much as three times the average equity REIT dividend return of between 2% and 3%.
Personally, I think mortgage REITs add a lot of vulnerability to a portfolio for not that great of a reward. The right mREIT can be fitting for dividend investors seeking higher-than-average returns, but it's important to understand the volatility that comes with it.
Economic conditions, interest rates, demand, and real estate market conditions all impact the business model's profitability, meaning far greater factors are at play than simple supply and demand like with equity REITs.
