Real estate investment trust (REIT) is a company whose activity consists of real property investing. REITs typically invest in particular real estate sectors, like residential, industrial and commercial real estate. There are also diversify and specialty REITs that own various types of real property, including the apartment complexes, hotels, medical centers, shopping malls, infrastructure – like cell towers and data centers -, office buildings, retail, and warehouses.
In this article, we will review the major types of REITs, the main risks and advantages of investing in mortgage real estate stocks and the differences between mortgage REITs and equity REITs. The following information will be useful not only for the beginners and real estate dealers but also for realtors and real estate agents in order to make a successful transaction.
First of all, let us define the main features of REIT. To to be identified as property invested fund, the company needs to satisfy several important criteria, listed below:
- invest not less than 75% of assets into the properties or similar assets;
- have at least one hundred shareholders;
- be no more than for a half in possession of five shareholders;
- receive at least 75% of the revenue from real estate;
- payout not less than 90% of the taxable revenue to the shareholders in the form of dividends.
If the company that presents itself as a REIT meets these criteria, then there will be the tax benefits for the corporation – the real estate fund will not pay corporate taxes on the income.
What Is a Mortgage REIT?
There are two main groups of real estate stocks:
- equity real property investment funds;
- mortgage real estate stocks, or mREITs.
In addition, there are also REITs that combine owning physical properties and mortgages in their portfolios. This type of company is called hybrid REITs. The investors who are putting money into hybrid real property stocks, gain revenue from both interest and rents.
Equity REITs are the companies that manage and own the real estate for rent – apartment complexes, offices, and shopping malls. Equity real estate stocks typically generate returns from the sale of the properties. However, equity REITs gain the most part of their income through rents.
Equity REITs usually pay out the expenses related to operating the properties which they own. After that, the investors receive the part of the income paid out annually as the dividends. The main risk of investing in equity real property stocks lies in the changeable market conditions that affect the share prices.
Mortgage REITs, or mREITs, are the companies that invest in mortgage-backed securities (MBS), residential and commercial mortgages and similar assets. This type of business differs greatly from the REITs that own properties. Mortgage real property stocks do not belong to the real estate branch, they are generally defined as financial stocks. MREITs lend money to the owners of the properties, either in a direct way – through mortgages, or indirectly – through the purchase of mortgage-backed securities.
Mortgage REITs play a vital part in facilitating the economy by buying investments secured by mortgages. In addition, mortgage real property stocks invest in commercial loans helping to purchase and sell the income-generating real properties.
Net Interest Margin
Mortgage REITs gain revenue from the net interest margin. This is a gap between the earnings from mortgage loan interest and the cost of financing these mortgages. If this amount is negative, it means that the investment decision proved incorrect, and in fact, the interest expenses are higher than the returns from the investments.
The process of investing in mREITs is similar to purchasing shares in public stock. The investor buys shares in mortgage real property stocks that are included in major stock exchanges. He can also buy the shares in an ETF, or exchange-traded fund, or mutual fund.
Due to the working principle of mREITs, they are influenced by the increase in interest rates. For instance, if the mREIT borrows money at 3% interest to finance mortgage loans that pay 4.5% interest, then the 1.5% gap is the net margin or the profit.
Mortgage REITs are usually popular among the real estate investors due to the sky-high dividends, from 10% to 15%.
The Types of Mortgage REITs
Mortgage real property stocks are subdivided into two major categories, according to the type of property these companies are focused at:
- residential mREITs;
- commercial mREITs.
The second distinctive feature is the type of management of mortgage REITs. There are two types:
- internal management;
- external management.
Internal management is the form of running the company when the REITs’ managers work for the company itself. Due to this reason, the compensation for their work is more transparent and can be influenced by the shareholders’ decision.
Mortgage REITs with external management are typically governed by the third party, and the compensation of their managers consists of the basic management fee, which is the interest of the assets, and a performance fee. In simple words, mREITS with external management are private organizations, or equity funds, whose specialization is financial instruments related to real estate.
Key Risks of Investing in Mortgage Real Estate Trusts
Investing in mortgage property investment funds has a wide range of benefits. In general, mortgage real property stocks function like banks, but with fewer risks. MREITs accumulate cheap capital and then loan it out at higher interest rates through the purchase of mortgage-backed securities. Despite good income potential and zero taxes, there is a certain amount of risks involved in putting money into mREITs.
Interest Rate Risk
Changes in interest rates are the principal factor that influences mREITs functioning because the net interest margin is their main source of income. Mortgage real property stocks usually manage the risks related to short-term loans with the help of various hedging strategies, like interest rate collars, interest rate swaps, and others. There are also other different ways to manage such risks, like selling assets when the interest rate is unstable.
There are two major types of securities purchased by mREITs:
- agency mortgages;
- non-agency mortgages.
Agency mortgages are supported by the government, and they are less exposed to default risk. The degree of the risk of non-agency mortgage loans is higher than for agency MBS because they often consist of borrowers who did not meet the agency standards.
On the other hand, sometimes non-agency REITs offer higher yields to compensate for the additional risks. So, if you have concerns about the credit risk, it is better to choose agency REITs to prevent this problem.
Prepayment risk may occur if the borrower pays the main part of the loan early, and the investor would not receive the interest payments in full. Prepayment risk is also possible if the borrower decides to refinance the loan or sell the property. Also, in case of damage to the house, the insurer may prepay the mortgage.
Mortgage REITs typically deal with short-term loans but on the other hand, they operate the long-term assets. The liquidity risk is connected with the inability of the mortgage REITs to rollover the borrowings because of the mismatch in the duration.
Liquidity risk means that the investor can not have access to his funds when a need arises. This problem becomes increasingly acute in times of crisis as it happened in 2008. Due to the guarantee from the government, agency REITs have better protection against the liquidity risk, in comparison with non-agency real property stocks.
Advantages of Investing in Mortgage REITs
The main advantage of investing in mortgage real property stocks is the perfect opportunity for the investors to diversify the investment portfolio without acquiring and managing the physical property. Moreover, 90% of the taxable income of REIT is distributed among investors. So, they receive dividends regardless of whether they realize capital gains or not.
The Bottom Line
A mortgage real estate stock can be a good addition to your portfolio if you are a risk-tolerant person and you are looking forward to receiving a high income without purchasing and owning the investment property.
The reason why the investors prefer mortgage real property stocks over the equity REITs is simple – mREITs have the potential to bring higher yields. Mortgage REITs are a perfect solution for the investors to entrust their funds to the professionals who can take advantage of the real property marketing conditions.
Before investing in mortgage REIT, you need to analyze the potential risks related to interest rates, prepayments, and credit and check the balance sheet of chosen mREIT, look at past performance and cash flow statements.
It is better to avoid single-family mortgage REITs. The key issue for many buyers is the affordability of the property, and it fits poorly with the prices for single-family homes, and it affects the REITs performance. In order to minimize the risks, the investor should choose large agency REITs or non-agency real property investment trusts with the returns that are higher than the average amount.
If you are the novice investor, you can contact the financial advisor or broker to receive the high-skilled consultation concerning investing in mortgage real property stocks.