Income investors are still scraping the bottom of the barrel for yield and finding a pittance. One area investors could consider offers high dividends, but they do come with some risks -- mortgage real estate investment trusts, or mREITs.
Real estate investment trusts, or REITs, are companies that invest in real estate or mortgages and allow investors to buy into those investments. One type of real estate investment trust, mREITs, invest nearly exclusively in mortgage-backed securities, or MBS.
Most mREITs buy mortgage-backed securities, or MBS, the type of securities sold by Fannie Mae, Freddie Mac and Ginnie Mae. Mortgage-backed securities are a bundle of loans wrapped up together and sold as one investment. Investors make money as borrowers pay off the loan, but there's also the risk that borrowers will pay off the loan early or not pay the loan at all.
That's why agency- or government-sponsored enterprise-backed MBS, and the mREITs that buy them, can be perceived as less risky -- the loans within the investment are guaranteed by Fannie, Freddie or Ginnie.
But there are residential mortgage-backed securities that are not backed by GSEs or agencies and there are commercial mortgage-backed securities as well.
MREITs buy mortgage securities and typically finance the investments using repurchase agreements, which is essentially borrowing.
"As a result, the primary source of income is interest income on these assets, and then our primary expense is the interest expense associated with the (repurchase agreements). Net interest income is our primary income. And then from there we have our operating expenses, which are usually pretty low because it doesn't take a lot of infrastructure to run these companies, and they end up paying sizable dividends based on that," says Don Ramon, CFO at Invesco Mortgage Capital, a manager of mREITs.
High dividends are also a result of the way REITs are structured. REITs are basically tax-exempt at the trust level, and to qualify as a trust, they must pay out most of their income -- 90 percent to be exact.
With no or very little taxes paid, REITs have more money to pay investors. And in general, mortgage REITs have paid investors particularly well over the past several years.
For instance, one of the bigger mREITs, Chimera, has a dividend yield of 14.3 percent as of March 2. Invesco Mortgage Capital is paying 15.2 percent.
But it's not all free money and party hats; there are some risks to investing in mREITs. For instance, some can be more highly leveraged than others, which can bring in some financing risk. Generally speaking, borrowing a lot is typically more risky than not borrowing at all.
"Mortgage REITs all use leverage. Invesco Mortgage Capital's debt-to-equity was 6.4 times, as of the period ending Dec. 31. That is right around average; it's anywhere from four to eight times debt-to-equity for most mREITs," Ramon says.
Agency-only REITs, those that invest only in agency- and GSE-backed securities, typically use more leverage "as they have less credit risk, or less perceived credit risk," he says.
On the other end of the spectrum, some mREITs try to get bigger returns by investing in lower credit quality rather than using extra leverage, for instance, buying non-agency residential MBS or commercial MBS.
Other risky aspects investors must be aware of include interest rate risk and liquidity risk, "which comes down to 'can we borrow money at reasonable terms. And is there availability of those funds?'" Ramon says.
With interest rates as low as possible right now, they have nowhere to go but up. That can mean trouble for any investments that pay a fixed rate of interest. If there are securities paying 5 percent, for instance, who would want to buy the ones that only pay 3 percent?
"The Fed has said they will hold rates until 2014, but they could be forced to start raising them earlier. As soon as the institutional investors think rates are going up, you will see people with fixed instruments get hurt," says Scott Cramer, a financial adviser and president of Orlando, Fla.-based Cramer and Rauchegger, Inc.
That means you could see the value of your investment drop, but according to Ramon, there are ways to hedge that interest rate risk.
To get a sense of the types of risks facing individual mREITs, examine the assets it holds.
"If you are looking at agency-only REITs, that is more limited to interest rate risk because they are not taking credit risk. Or you can have a REIT that wants to take greater credit risk and so they'll be buying subprime assets," says Ramon.
Knowing what types of loans the REIT specializes in can give you a sense of where the risks lie as well.
"REITs are very specialized. Find out what their focus is, whether it's fixed-interest or variable-rate REIT," he says.
Mortgage REITs specializing in fixed rates will be more negatively impacted by rising rates than variable-rate loans.
"Choose your managers carefully because you're relying on them to pick the best mortgages and know when to sell and manage the mortgages that are held within the REIT," Cramer says.
Look for managers with a long track record in mortgage REITS. They should have experience in several different types of markets ideally -- both low- and high-interest rate environments.
Keep in mind that the portfolio can change on a month-to-month basis, and the price can go down as well as up. Investors should carefully weigh the risks when eyeing the tempting dividend yields.
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