We’ve already discussed Real Estate Investment Trusts and why they’re a good option for income-seeking investors. REITs can offer an easy solution for income starved investors who need some diversification in their portfolio. A quick exposure to the country’s real estate market is likely to augment any dividend oriented portfolio.
While we’re particularly keen on high-quality REITs that offer sizable returns, investors need to be aware of the different types of REITs available to them. As promised last week, here’s a closer look at one particular type of REIT available to retail investors – mortgage REITs or mREITs.
We’ve been over REITs last week. Here’s a quick runthrough of what they are and how investors rely on them. REITs are basically investment trusts that invest in property. Shares of the trust trade on the stock market like regular stocks. However, there is one clever difference between a REIT and a traditional stock. The managers of REITs can avoid paying taxes at the corporate level so long as they distribute 90% of the income from the properties.
In other words, the managers and the trust acts as a custodian of the property portfolio on behalf of the investors. Investors pay taxes on the individual level and enjoy high yields on their investment.
It all works out brilliantly well for everyone involved. Investors enjoy a high dividend yield and appreciation on the property portfolio. While the trust can earn management fees and has access to a wdidr pool of debt and equity capital to fund property developments.
But not all REITs are created equally. Some invest in complex instruments and have very different characteristics. The most common and easy to understand type of REITs are ones based on equity. The less common ones are based on property mortgages. These are probably riskier but also likely to be more lucrative. Here’s what you need to know about them both:
Mortgage Vs. Equity
Put yourself, for a moment, in the shoes of a REIT trust manager. You have access to a vast sum of capital and are trusted to make the right decision for your investors. Your mandate is simple – profit and stability.
REIT investors want high income, moderate capital appreciation, and maximum security. These financial instruments are meant to fund people’s daily lives, so they can’t be too volatile.
As the manager, you can play by the traditional strategy and start buying properties to add to a portfolio. You put a certain amount of money into each property as a down payment and access a bank loan (mortgage) to fund the rest. Since you own equity in the properties, this strategy will help you create a traditional equity REIT or eREIT.
On the other hand, you can ignore the properties and buy different forms of mortgages instead. In effect, you have reversed the roles and become the lender who helps people buy properties. You don’t need to maintain the sites, pay for management, or find tenants. You own contracts and earn interest payments from a variety of institutions and individuals. This is how you create a mortgage REIT or mREIT.
When Congress created them in the 1960’s, the instruments were meant to make it easier to diversify. These securities can help average investors, with limited resources, get access to a deeply professional class of investment. Now, mREITs can access a deep and readily-available pool of debt and equity to invest in long-term interest-paying real estate securities.
Types of MREITs
MREITs come in different flavors as well. It all depends on what the mREITs invest in. If they pick residential properties or commercial ones. They can also be classified on the basis of management.
So MREITs are divided based on the property type or the management style.
Property Type: mREITs can invest in either people’s homes or offices. The difference in property type makes all the difference in the world. Residential properties are funded by mortgages that offer very little yield. This is because the loans on people’s homes are backed by government sponsored entities such as Fannie Mae (FNMA), Freddie Mac (FMCC), or Ginnie Mae. In other words, the government will step in if the homeowner defaults on the loan, which means the risk is nearly zero and the interest rate is relatively low. To improve performance, mREITs borrow heavily and pump up returns. The average mREIT that invests in residential apartments will borrow $6 or $8 for every $1 in investment.
Then there’s commercial property. Because the government doesn’t back these loans, the interest rates are higher, the risk is higher, and mREITs have to take far less leverage to make the same amount of profits.
Management Style: mREITs can be managed either internally or externally. This means the managers of the trust can be either part of the trust (internal) or part of a larger third-party asset manager who owns the trust (external). The key difference is the level of transparency and control mREIT shareholder have on internal managers. Although investors know external managers are paid a fixed percentage of assets for management and performance fees based on the growth in book value, the payment isn’t entirely transparent.
mREITs may be accessible by the average investor but they’re certainly not designed for them. Traditional REITs are safer and more stable. They’re also easier to understand. So, the average investor knows what they’re getting into with a common REIT.
A mREIT, on the other hand, works like a complicated bank. With higher rewards comes higher risk and added complexity. Sky high yields on mREITs come at a price. A sudden jump in interest rates or a plunge in commercial property prices can have devastating effects on the trust. Also, since interest rates and rental yield move around a lot mREITs can never guarantee a fixed dividend. Unlike dividend stocks, these mREITs must decide how much they can pay investors based on how much money they have made in any quarter.
Analyzing a mREIT is also tricky business. The managers use complex derivative like swaptions and interest rate hedges to augment the earnings. In other words, the management is doing things that have less than obvious consequences.
During the financial meltdown and property market collapse of 2008, these mREITs played a key role. From the FED’s quantitative easing decisions to the volatility in the mortgage market, these mREITs are subject to complicated and often obscure risks.
For the average investor, these instruments are worth a look only if they have the time and experience to do their research thoroughly. Even then, mREITs should only form a small portion of the overall portfolio to limit risks.
mREITs are endlessly fascinating and superbly lucrative instruments. Unlike traditional REITs, these trusts buy or originate mortgages. In other words, they act as the lender for the property market.
mREITs come in a variety of flavors. They can either invest in mortgages from people’s residences or from commercial properties for businesses. mREITs be managed by people within the trust or from a third party. Also, these instruments can either borrow a lot of money to buy mortgages or buy highly lucrative commercial mortgages.
In the end, these are complicated instruments that require a lot of research and work to figure out. If you’re willing to do dig deep and understand the market completely, these securities are worth a look. You can augment your portfolio by adding in mREITs that yield double digit percentages every quarter. Just make sure you diversify and limit exposure to this asset class.