Pros and Cons of Investing in Mortgage REITs
There are plenty of ways to invest in real estate. Whether you want to own and manage physical properties or contribute to a real estate investment trust (REIT), investors can benefit from different types of real estate income. Today, we’ll review mortgage REITs, how they work, how to invest, and some pros and cons to consider. Read along to learn more about this unique real estate investment method.
Contents of This Article:
- What Are Mortgage REITs?
- Mortgage REITs Vs. Equity REITs
- How to Invest in Mortgage REITs
- Pros and Cons of Investing in Mortgage REITs
- What’s Your Next Investment Move?
What Are Mortgage REITs?
While you may associate real estate investing with buying physical properties, there are plenty of ways to invest without buying or managing individual properties. Real Estate Investment Trusts (REITs) are just one of the ways investors can add to their portfolio without the hassle of managing a property.
REITs are companies that finance, own, and operate income-producing real estate. Mortgage REITs, a subcategory of REITs, are investments in purchased or originated mortgages and mortgage-backed securities (MBS) that earn income from the interest paid on those assets. Some mortgage REITs may also earn loan origination and servicing fees, making them similar to financial stocks.
However, mortgage REITs are different than other real estate investments, as they earn a profit on their net interest margin. Additionally, they use several different funding sources to originate and purchase mortgages. These sources may include equity, repurchase agreements, structured financing, credit facilities, and more. Here’s an overview of how mREITs work.
How Mortgage REITs Work
Suppose an mREIT raises $150 million in equity from investors and secures an additional $450 million from other sources at an average cost of 1.5%, bringing its total investable capital to $600 million. They then use the $600 million to purchase a portfolio of mortgage-backed securities.
If the MBS portfolio has an average weighted yield of 4%, the mREIT can earn $24 million of interest income annually. At the same time, with a 1.5% cost of funding, it would have $6.75 million in funding costs. So, you’d want to subtract the funding costs from the income, meaning the mREIT generates $17.25 million of net interest margin each year. Luckily for investors, IRS regulations require that mREITs distribute 90% of their net income to shareholders in the form of dividends.
Mortgage REITs Vs. Equity REITs
There are two main types of REITs, including equity REITs and mortgage REITs. We’ve gone over how mREITs work, but it’s important to understand the difference between those and equity REITs.
Equity REITs are the most common type of REIT, and they own and operate the properties in their holdings. This type of investment method gives investors access to diverse portfolios of income-producing real estate that they may not be able to afford on their own.
That said, an equity REIT usually generates revenue through rental income, while mortgage REITs generate revenue through interest income from mortgages or MBS. Additionally, equity REITs are known for their stable income, as both mortgage and equity REITs are required to distribute 90% of their income to shareholders.
How to Invest in Mortgage REITs
Investing in mREITs isn’t very difficult and can be done fairly quickly. All you have to do is sign up with a brokerage, deposit enough funds, and purchase shares. If you don’t have a brokerage account, look for a reputable online brokerage that offers a variety of investment options, including REITs.
Setting up an account is the easy part. Next, you’ll want to do some research to find which mortgage REITs you want to invest in. It’s important to look thoroughly at each option’s performance, dividend history, how they’re managed, and what types of mortgages they invest in. Research during this step is crucial to decide which mREITs are a good fit for your portfolio.
Along with researching different options, you’ll want to review the pros and cons of investing in mREITs. We’ll go over some of those next.
Pros and Cons of Investing in Mortgage REITs
Like any investment method, investing in mortgage Real Estate Investment Trusts (REITs) comes with its own set of advantages and disadvantages. Here are some of the pros and cons to consider if you’re looking into mortgage REITs.
Benefits of Investing in Mortgage REITs
- High-Yield Dividends- Mortgage REITs often offer high dividend yields compared to other investments. This can be attractive for income-focused investors who want regular, steady cash flow.
- Diversification- Investing in mortgage REITs allows you to diversify your investment portfolio. It offers exposure to the real estate market without the direct ownership and management responsibilities associated with physical properties.
- Liquidity- Mortgage REITs trade on stock exchanges, providing investors with liquidity. Shares can be bought or sold easily during market hours, making the process simple for even the busiest investors.
- Tax Advantages- REITs are required to pass 90% of their income to shareholders, usually resulting in favorable tax advantages for investors. For example, dividends received from REITs may be taxed at a lower rate than ordinary income.
Risks of Investing in Mortgage REITs
- Interest Rate Sensitivity- Mortgage REITs are highly sensitive to interest rate changes. For instance, rising interest rates can lead to a decline in the value of existing mortgage-backed securities, potentially affecting the REIT’s performance.
- Market Risks- Mortgage REITs can be influenced by broader economic factors and market conditions. Economic downturns or disruptions in the mortgage market can impact their performance, leaving investors with less income than expected.
- Limited Appreciation Potential- Unlike equity REITs that own physical properties with the potential for appreciation, mortgage REITs may have limited potential for appreciation.
- Dividend Volatility- While mortgage REITs typically offer high dividend yields, these dividends can be volatile and may fluctuate based on interest rate movements, market conditions, and the REIT’s performance.
What’s Your Next Investment Move?
With so many ways to get involved in real estate, investors have a lot of decisions to make. For instance, if your goal is to own real estate and earn steady rental income, you may look at owning and operating your own income properties. On the other hand, if you want a more hands-off approach while still investing in real estate, you may consider an equity or mortgage REIT. No matter which route you decide to go, it’s important to have a solid plan in mind.
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