Real estate can be an important part of any investor’s portfolio, but investing in real estate can be costly and confusing. Most investors lack either the means or inclination to buy and manage individual rental properties. This is where real estate investment trusts, or REITs, come into play.
“REITs are creatures of the federal tax code,” says Zach Swartz, a partner at the law firm Vinson & Elkins who specializes in REITs and corporate real estate.
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REITs were established by Congress to “democratize” real estate investment, he says, by giving regular Americans — not just the wealthy and institutional-level investors — the ability to make stock-based investments in real estate companies and securities.
Most REITs are equity REITs, which own or manage income-producing real estate and generate income for shareholders through the rents earned on properties. But there’s another subset of REITs that can provide both income and diversification for an investor’s portfolio: mortgage REITs, or mREITs.
How exactly do mREITs work, and why would you want them in your portfolio? Consider the following:
— What are mortgage REITs?
— Why invest in mREITs?
— mREIT performance.
— Risks of mREITs.
— Ways to invest in mREITs.
What Are Mortgage REITs?
Mortgage REITs invest in residential or commercial mortgages or mortgage-backed securities, or MBS.
“Think of equity REITs as owning the buildings and mREITs as owning the debt on the buildings,” says Iman Brivanlou, head of income equities at TCW.
For investors, this means investing in equity REITs gives you exposure to the real estate market, while investing in mREITs gives you exposure to the real estate debt market.
Mortgage REITs can invest in different types of real estate debt. For example, commercial mREITs invest primarily in commercial mortgages or commercial MBS, such as office or industrial spaces, self-storage properties, hotels or apartments. Residential mREITs, meanwhile, invest in residential mortgages and residential MBS.
“Born out of the need for a liquid and accessible investment in the mortgage market, mREITs support homeowners and businesses by enhancing credit availability,” says Philip Seagraves, associate professor and director of finance and real estate studies at Middle Tennessee State University. “In other words, mREITs bring more money into the system that can be loaned out to purchase real estate.”
Why Invest in mREITs?
The primary investment case for mREITs can be summarized in one word: income.
To qualify as a REIT, the company must distribute at least 90% of its taxable income to shareholders as dividends.
“REITs are permitted to deduct dividends paid to their shareholders from their corporate taxable income,” Swartz says. “As a result, most REITs distribute at least 100% of their taxable income to their shareholders and pay no corporate tax.”
This can result in a sizable distribution for investors — far higher than you’ll likely get on traditional dividend-paying stocks.
“Investors tend to be drawn to the high dividend yields provided by most mREITs, and these can get as high as about 10%,” Brivanlou says. “Dividend yields are a direct function of the riskiness of the underlying collateral as well as the amount of leverage employed by the mREIT, so we would urge caution and increased scrutiny if an mREIT is offering an unusually high yield.”
Investing in mREITs can also provide diversification.
Diversification comes from the fact that real estate tends to dance to a different tune than more traditional investments like stocks and bonds. In technical terms, REITs are known to zig, while other sectors zag. Having some zig to go with your zag helps prevent your entire portfolio from tanking all at once.
mREIT Performance
Mortgage REITs had a rough year in 2022. The FTSE Nareit Mortgage REITs Index fell about 35% in the year, compared to about a 20% decline in the equity markets. While all property sectors were down, commercial financing mREITs were hit particularly hard.
These investments are faring better in 2023, with the FTSE Nareit Mortgage REITs Index down 6.2% from Jan. 1 through April 27. Does that mean the future is looking up for mREITs?
“The current landscape for commercial mREITs is challenging,” Swartz says. “Increased employer flexibility and employee demand for work-from-home arrangements has led to a reduction in demand for office space. This trend has contributed to a steadily increasing level of defaults on office loans, including loans held by commercial mREITs.”
Unfortunately, he says industry experts expect this trend to continue.
Interest rates play an important role in the mREIT landscape. “A significant number of commercial mortgage loans will be up for refinancing in the next couple of years,” Swartz says. “If interest rates remain where they are now, lending rates will be significantly higher than when these loans were last refinanced or originated, which could cause significant distress in the commercial real estate sector.”
Residential mREITs, naturally, aren’t affected by the challenges facing office space companies in the new work-from-home world. As a result, they’ve generally fared better than commercial mREITs coming out of the pandemic, Swartz says.
“However, residential mREITs use leverage to enhance the returns on the residential mortgages and MBS that they purchase or originate,” he says. “Accordingly, rising interest rates could also be a problem for residential mREITs that have borrowed too much or not properly hedged their interest rate risk.”
[READ: 7 Stocks That Outperform in a Recession.]
Risks of mREITs
As is always the case with investing, you shouldn’t venture into the realm of mREITs without understanding the potential risks, of which there are several. Here are some of the primary risks of investing in mREITs.
Interest rate risk. Perhaps the most recognized risk to mREITs is interest rate risk, or the risk that changes in market interest rates could negatively impact investment returns.
“When interest rates rise, mREIT returns are generally expected to decline due to higher borrowing costs and a decrease in the value of their MBS holdings,” Seagraves says. “Conversely, when interest rates fall, mREIT returns may increase as borrowing costs decline and the value of MBS holdings appreciates.”
Many mREITs employ hedging strategies to minimize interest rate risk, but this can be tricky to manage over the long term.
Credit risk. Credit risk is the risk that borrowers may default on their mortgages.
“The performance and value of an mREIT’s investments depend upon the ability of sponsors and borrowers to operate the underlying real estate so that they produce cash flows adequate to pay interest and principal due on the mREIT’s investments,” Swartz says. “This means that mREITs are subject to the creditworthiness of the ultimate borrowers of the loans and MBS that mREITs hold.”
Brivanlou says that agency mREITs, which invest in residential debt backed by federal government agencies like Fannie Mae or Freddie Mac, tend to have lower credit risk than non-agency mREITs, which invest in nongovernment debt.
Some REITs also hold floating rate assets, which could be a boon in rising interest rate environments as they can generate more revenue for the mREIT, Swartz says. However, if rates rise too quickly, it could strain borrowers to the point of inability to pay.
Prepayment risk. Prepayment risk is the risk that borrowers may repay their debts early, leading to a loss of future cash flow.
“Borrowers tend to repay higher yielding loans early and will refinance if/when interest rates drop,” Brivanlou says. “This tends to lower the income generated by the mREITs.”
Margin risk. Margin is the use of leverage to amplify returns on an investment. In practice, it involves borrowing money to pay for an investment, and while it can increase the potential upside, it also amplifies the potential downside.
“Most mREITs employ leverage to produce their returns,” Brivanlou says. “Without leverage these entities could not operate profitably, which makes them dependent on a stable source of funding.”
The risk to this debt dependence is not only that the mREIT may have a duration mismatch, such as by funding long-term lending with short-term facilities, he says, but also the potential for a margin call when asset prices decline. A margin call means the mREIT would need to add more funds to the account because the overall balance has dropped too low.
Capital markets risk. Since mREITs are required to distribute 90% of their taxable income to shareholders, they have a limited ability to build up working capital to finance operations.
“As a result, mREITs often must raise capital, such as through the issuance of stock or other equity instruments or by borrowing debt, to fund growth and finance their businesses,” Swartz says. “However, the equity and debt markets are volatile, and mREITs may not be able to raise capital when needed on attractive terms, or at all.”
Ways to Invest in mREITs
If you view the potential rewards as worth the risks to investing in mREITs, then the question becomes how to invest in mREITs.
You can purchase shares in individual publicly traded mREITs just as you would any stock. For example, Franklin BSP Realty Trust Inc. (ticker: FBRT) is a commercial mREIT with more than $1 billion in assets under management, while AGNC Investment Corp. (AGNC) is a residential mREIT that invests in agency MBS and has about $5.8 billion in assets under management.
You can find more individual mREIT investment options on the National Association of Real Estate Investment Trusts’s (Nareit) REIT and Publicly Traded Real Estate Company Directory, or by viewing the holdings included in the FTSE Nareit Mortgage REITs Index.
For a more diversified approach, you might consider an mREIT exchange-traded fund or mutual fund, which can hold a range of different mREITs. Examples include the iShares Mortgage Real Estate Capped ETF (REM) and VanEck Mortgage REIT Income ETF (MORT).
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Investing in Mortgage REITs (mREITs) in 2023 originally appeared on usnews.com
Update 04/28/23: This story was previously published at an earlier date and has been updated with new information.
