Mortgage Reits: A Smart Investment Strategy?

Mortgage REITs, or mREITs, are a type of real estate investment trust (REIT) that focuses on real estate financing. They provide liquidity to the real estate market by purchasing or originating mortgages and mortgage-backed securities (MBS), earning income from the interest on these investments. mREITs are an attractive investment opportunity due to their history of relatively high dividends and the potential for capital appreciation. They are traded on major stock exchanges, and investors can purchase shares in an mREIT as they would any other public stock or as part of an ETF or mutual fund. However, it is important to consider the risks associated with mREITs, such as interest rate risk, prepayment risk, credit risk, and rollover risk.

High dividend yields

Mortgage REITs (mREITs) are a great source of passive income as they are legally required to distribute at least 90% of their taxable income in the form of dividends. This often leads to stocks yielding well above the average yield of the S&P 500 index, which is 1.3%—it is not uncommon to find shares of REITs trading with very high dividend yields, sometimes in the double-digit range.

Mortgage REITs purchase mortgages and then use the monthly mortgage payments to distribute dividends. They profit from the difference in rates. For example, American Capital Agency, or AGNC, was founded in 2008 and focuses its investment capital on residential mortgage pass-through securities. The trust’s portfolio includes agency mortgage-backed securities, collateralized mortgage obligations, and non-agency mortgage-baked securities. AGNC generated revenue of $1.3 billion in 2021 and is valued at $7.8 billion today. As of its most recent close, AGNC stock yields 9.7%, nearly 7.5 times the average yield of the market index.

Mortgage REITs can also help investors diversify their portfolios. Not many people can purchase commercial real estate to generate passive income, but REITs offer the general public the ability to do exactly this. They are highly liquid, and most can be bought or sold with the click of a button.

However, it is important to note that high yields can come with high risk. Investors should carefully assess the fundamentals to ensure that high yields are sustainable. Dividend safety, valuation, management, balance sheet health, and growth are also essential factors to consider.

Additionally, most REIT dividends are taxed at a higher rate than most dividends. While REITs do qualify for the 20% pass-through deduction, investors will likely need to pay a large amount of taxes on REIT dividends if they hold them in a standard brokerage account.

Liquidity provision for the real estate market

MREITs provide funding for both residential and commercial mortgages, as well as residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). This liquidity helps homeowners and businesses access mortgage credit, and has been instrumental in providing mortgage loans to 1 million homebuyers.

The liquidity provided by mREITs is critical to the smooth functioning of the real estate market. Without them, the industry would have far less liquidity, making it harder for borrowers to secure financing. mREITs, therefore, play an important role in the economy by helping to facilitate the housing market and, on the commercial side, the buying and selling of income-producing real estate.

The liquidity offered by mREITs also brings benefits to investors. mREITs are traded on major stock exchanges, providing investors with the ability to buy and sell with the click of a button. This level of liquidity is not available through direct investment in mortgage loans and mortgage-backed securities.

In addition to liquidity, mREITs offer investors the potential for relatively high dividend yields, particularly in a rising interest rate environment. They also provide portfolio diversification, allowing investors to access the real estate market without purchasing physical property.

Tax advantages

Mortgage REITs, or mREITs, are investments in purchased or originated mortgages and mortgage-backed securities (MBS) that earn income from the interest paid on those assets. They are essential in providing liquidity in the real estate market.

High Dividend Yields

MREITs have historically provided high dividend yields, which are taxed as ordinary income. The IRS requires that shareholders receive at least 90% of a REIT's income, which is often much higher than the average stock on the S&P 500. This makes REITs an attractive investment for those seeking higher yields than what can be earned in traditional fixed-income markets.

Capital Gains Tax Treatment

The portion of the dividend that is a capital gain or loss is taxed at 0%, 15%, or 20%, depending on the investor's income level for the year in which the gain is received. This occurs when the REIT sells property it has held for at least a year.

Return of Capital

A portion of the dividend may be listed as a non-taxable return of capital, which occurs when the REIT's cash distributions exceed earnings, such as when the company takes large depreciation expenses. This part of the dividend is not taxable in the year it is paid but is taxed later as a long- or short-term capital gain or loss when the investor sells their units.

Pass-Through Deduction

Qualified REIT dividends may enjoy additional tax breaks under the Tax Cuts and Jobs Act (TCJA). The act provides a 20% deduction for pass-through business income, which is set to expire at the end of the 2025 tax year.

Low correlation with other assets

One of the main reasons people invest in mortgage REITs is their low correlation with other assets. This makes them an excellent portfolio diversifier, reducing overall portfolio risk and increasing returns.

Mortgage REITs (mREITs) are investments in purchased or originated mortgages and mortgage-backed securities (MBS) that earn income from the interest paid on those assets. They are essential in providing liquidity in the real estate market.

MREITs help provide funding for mortgage credit for both homeowners and businesses. They use private capital to buy residential mortgages and mortgage-backed securities, providing liquidity and credit to home mortgage markets. This liquidity is crucial for the functioning of the real estate industry, making it easier for borrowers to find financing opportunities.

MREITs have a history of providing competitive total returns, based on high, steady dividend income and long-term capital appreciation. Their low correlation with other assets makes them an attractive addition to many portfolios, especially for those seeking to reduce risk and increase returns through diversification.

Additionally, mREITs provide a simple way to hold an equity investment in the mortgage market, offering the liquidity and transparency of publicly traded equities. This advantage is not available through direct investment in mortgage loans and mortgage-backed securities.

With their low correlation to other assets, mREITs can help balance out a portfolio, reducing the impact of fluctuations in other asset classes. They are a unique investment option that can provide stable and competitive returns, making them a valuable consideration for investors seeking diversification and stable returns.

Diversification of investment portfolios

Real estate investment trusts (REITs) are an important consideration for investors looking to diversify their portfolios and reduce risk.

REITs are a type of investment trust that owns and manages income-producing real estate, providing investors with exposure to the real estate market. They are traded on major stock exchanges and are a distinct asset class with a low-to-moderate correlation with other sectors of the stock market, as well as bonds and other assets. This means that adding REITs to a portfolio can smooth out overall volatility and increase long-term returns without increasing risk.

REITs are also attractive to investors because they offer high, steady dividend income and the potential for moderate long-term capital appreciation. They are required to distribute at least 90% of their taxable income to shareholders annually, providing substantial dividend yields.

Mortgage REITs (mREITs) are a subcategory of REITs that focus on real estate financing. They invest in residential or commercial mortgages or mortgage-backed securities (MBS). mREITs are similar to financial stocks in that they earn profits through net interest margins. They use diverse funding sources, such as equity and debt, to purchase mortgage-related assets.

While mREITs can provide high dividend yields, they also come with higher risks compared to other investments, including interest rate risk, prepayment risk, credit risk, and rollover risk.

Overall, REITs, and specifically mREITs, can be a valuable addition to a well-diversified investment portfolio, offering exposure to the real estate market, high dividend yields, and the potential for capital appreciation. However, investors should carefully consider the risks associated with mREITs before including them in their portfolios.

Frequently asked questions