Investing in Mortgage REITs

Investing in Mortgage REITs

Mortgage REITs, or mREITs, provide real estate financing by originating or purchasing mortgages or mortgage-backed securities. They are an essential part of the residential mortgage market, helping to finance roughly 1.7 million homes each year. They also support the commercial real estate sector by providing loans to develop, acquire, reposition, and own income-producing properties.

Here’s a closer look at the overall mortgage REIT market, the sector’s unique risks, and some interesting mREITs to consider. Image source: Getty Images. Understanding mortgage REITs

Mortgage REITs are a subcategory of the real estate investment trust ( REIT ) segment that focuses on providing real estate financing. The entities purchase or originate mortgages and mortgage-backed securities, earning 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 earn a profit on their net interest margin, which is the spread between the interest income generated by their mortgage assets and their funding costs. Mortgage REITs use various funding sources to originate and purchase mortgages and related securities, including common and preferred equity , repurchase agreements, structured financing, convertible and long-term debt, and credit facilities.

mREITs use those funding sources to acquire mortgage-related assets. Some mREITs will originate loans they hold on their balance sheet and sell them to other buyers, including government agencies, banks, or investors. In addition, mREITs purchase mortgages and mortgage-backed securities. They collect the fees and loan interest generated by mortgages, keeping what remains after paying funding and operating expenses.

Here’s an example of how mREITs work. Let’s say an mREIT raises $100 million of equity from investors to buy mortgages. It secures another $400 million from other sources, at an average funding cost of 2%, allowing it to purchase $500 million of mortgage-backed securities.

If the loans had an average weighted yield of 3%, they would generate $15 million of interest income annually. Meanwhile, at a 2% cost of funding, it would have $8 million of annual funding costs, allowing the mREIT to generate $7 million of net interest margin each year.

IRS guidelines for mREITs require them to distribute 90% of net income to shareholders via dividend payments , which explains the high dividend yields for most mREITs. Risks of investing in mortgage REITs

Mortgage REITs are riskier than many other investments, including other REITs, because they face certain specific risks, including: Interest rate risk: While changes in interest rates affect REITs overall, they have an even greater effect on mREITs because changes in short- and long-term interest rates can affect net interest margins by increasing the costs of funding and reducing interest income. Interest rate changes can also affect the value of an mREIT’s mortgage assets, affecting its net asset value and share price.

Prepayment risk: Mortgage borrowers can refinance their loans or sell the underlying real estate. When that happens, it forces the mREIT to reinvest the repaid loan proceeds in the current interest rate market, which might be lower than the rate on the existing mortgage.

Credit risk: mREITs focused on commercial mortgages can face credit risks if borrowers default.

Rollover risk: Residential mortgage REITs tend to own long-term mortgages and mortgage-backed securities. However, they often fund these purchases with shorter-duration borrowing since short-term interest rates are generally lower than long-term rates. This funding strategy creates rollover risk. The mREIT must obtain funding at attractive rates to roll over loans as they mature.

3 mortgage REITs to consider in 2021

There are almost two dozen mREITs focused on home financing and another 18 focused on the commercial mortgage sector. Most have underperformed the S&P 500 in recent years due to fluctuating interest rates. However, a few mREITs stand out as strong performers in this volatile sector:

Here’s a closer look at the leading mortgage REITs. Arbor Realty Trust

Arbor Realty Trust is an mREIT that finances commercial real estate. It focuses on making loans backed by multifamily properties, although it also finances student housing, land, healthcare facilities, offices, single-family rentals, and other property types.

The real estate financing company has three business platforms: Balance sheet loan origination : Arbor underwrites loans that it holds on its balance sheet.

Government-Sponsored Enterprise (GSE)/Agency loan origination : The REIT originates small-balance loans ($1 million to $8 million) that it sells to Fannie Mae, Freddie Mac, the Federal Housing Administration, and other agencies.

Servicing : Arbor provides servicing on multifamily loans primarily held by GSEs. Arbor’s […]

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