Mortgage REITs (mREITs) provide real estate financing by issuing or purchasing mortgages or mortgage-backed securities. They are an integral part of the mortgage market, helping to finance approximately 1.4 million homes each year in the U.S. They also support the commercial real estate sector by providing financing for the development, acquisition, repositioning and ownership of income-generating properties.
Here, we take a closer look at the mortgage REIT market as a whole and the risks specific to the sector, plus we'll discuss three interesting mREITs worth considering.
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Understanding Mortgage REITs
Understanding Mortgage REITs
Mortgage REITs are a subcategory of the real estate investment trust (REIT) segment that focus on real estate lending. These entities purchase or issue mortgages and mortgage-backed securities and earn interest income from their investments. Some mREITs also earn loan origination and servicing fees. These factors make mREITs similar to financial stocks.
Mortgage REITs make money differently than other real estate investments. They make money on a net interest margin, which is the difference between the interest income earned on their mortgage assets and their funding costs. Mortgage REITs originate and purchase mortgages and related securities using a variety of funding sources, including common and preferred stock, repurchase agreements, structured loans, convertible and long-term notes, and lines of credit.
Mortgage REITs use these funding sources to acquire mortgage-related assets. Some mREITs originate loans that are held on their balance sheets and then sell them to other buyers, such as government agencies, banks, or investors. Additionally, mREITs purchase mortgages and mortgage-backed securities. They collect fees and loan interest accrued by the mortgages and retain any that are left over after paying financing and operating expenses.
Here's an example of how an mREIT works: Suppose an mREIT raises $100 million in capital from investors to buy mortgages, secures another $400 million from other sources at an average funding cost of 2%, and buys $500 million of mortgage-backed securities.
If the average weighted yield on the loans is 3%, then interest income of $15 million per year will be generated, whereas if the cost of financing is 2%, then the annual funding cost will be $8 million and the mREIT will be able to generate a net interest margin of $7 million each year.
IRS guidelines for mREITs require them to distribute 90% of their net income to shareholders through dividends, which is why most mREITs have high dividend yields.
risk
Risks of investing in mortgage REITs
Mortgage REITs are riskier than many other investments, including other REITs, because they face certain risks, including:
Interest Rate Risk: Interest rate fluctuations affect REITs overall, but have a greater impact on mREITs, as fluctuations in short-term and long-term interest rates can affect net interest margins by increasing funding costs and reducing interest income. Interest rate fluctuations can also affect the value of an mREIT's mortgage assets, affecting its net asset value and stock price. Prepayment Risk: Mortgage borrowers can refinance their loans or sell the underlying properties. In that case, mREITs would be forced to reinvest the proceeds of the repaid loans into the current interest rate market, where the interest rate may be lower than the interest rate on the existing mortgage. Credit Risk: Mortgage REITs that focus on commercial mortgages may face credit risk if borrowers default. Mortgage REITs that focus on government-guaranteed mortgages don't have to worry as much about this. Rollover Risk: Mortgage REITs tend to hold long-term mortgages and mortgage-backed securities. However, because short-term interest rates are generally lower than long-term interest rates, mREITs often finance these purchases with short-term borrowings. This funding strategy creates rollover risk: mREITs need to raise capital at attractive interest rates to roll over maturing loans.
The 2 Best Mortgage REITs
Two Mortgage REITs to Consider in 2024
There are dozens of mREITs, and many have underperformed the S&P 500 in recent years due to fluctuating interest rates. But a few mREITs stand out as strong contenders in this volatile sector and may be worth considering for patient investors looking for a high income stream.
Data source: Ycharts and Google Finance. Market cap and dividend yield as of May 1, 2024. Top Mortgage REITs Ticker Asset Type Market Cap Dividend Yield Arbor Realty Trust (NYSE:ABR) Commercial $2.5 billion 13.24% Annaly Capital Management (NYSE:NLY) Residential $9.6 billion 13.79%
Here's a closer look at the two major mortgage REITs.
Arbor Real Estate Trust
Arbor Realty Trust is a commercial real estate mREIT that focuses on lending against multifamily residential collateral, but also lends against student housing, land, medical facilities, offices, single-family rental properties, and other property types.
The real estate finance company has three business platforms.
Balance Sheet Loan Origination: Arbor underwrites loans that it holds on its balance sheet.Government Sponsored Enterprise (GSE)/Government Agency Loan Origination: The REIT originates small loans ($1 million to $8 million) and sells them to Fannie Mae, Freddie Mac, the Federal Housing Administration, and other government agencies.Servicing: Arbor primarily services multifamily loans held by the GSEs.
Arbor's business model provides multiple revenue streams. The mREIT generates recurring long-term cash flows from service fees, escrow revenues and net interest income. It also generates a one-time origination fee. This strategy gives it an advantage over mREITs that focus solely on revenue from net interest margins.
Its diversified operating platform and focus on multifamily has allowed it to generate fairly stable earnings through all market cycles. Arbor increased its annual dividend for the 10th consecutive year in 2021. This is notable because mREIT dividends have historically fluctuated due to the impact of interest rates on net interest margins.
Annaly Capital Management
You can't talk about this sector without mentioning Annaly Capital Management, the largest mREIT on the market. Annaly specializes in mortgages, with roughly three-quarters of its capital allocated to government-guaranteed mortgage-backed securities. These offer relatively low yields compared to commercial mortgages, so Annaly uses significant financial leverage. As of the end of the first quarter, Annaly had $11.5 billion in net worth and an investment portfolio of $84.4 billion.
While Annaly is not completely immune to interest rate risk, the company has done a good job of hedging against rising interest rates through futures and swaps, and has been aggressively ramping up its hedging efforts in recent quarters. While the stock price can be a roller coaster ride, over the long term the business has performed well. In fact, since its IPO in the late 1990s, Annaly has delivered a total return of 726% to investors, more than 200% higher than the S&P 500 over that same period.
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Mortgage REITs offer higher dividends and higher risk
mREITs can generate large net interest margins when the spread between short-term interest rates (to borrow) and long-term interest rates (to lend) is large. Unfortunately, this spread does not usually remain wide over the long term, which is why mREITs tend to be very volatile.
Because of this risk, mREITs aren't necessarily the best choice for income-seeking investors, as their yields can be high and volatile, but some interesting mREITs are worth considering, as their differentiated business models protect them from sector-wide volatility.
Matt DiLallo has invested in Annaly Capital Management. The Motley Fool has no investment in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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