Investors have been attracted to ETFs tracking real estate investment trusts for their high yields and outperformance relative to the S&P 500 in recent years. Within the sector, mortgage REITs generate the highest yields, but they are not without their risks.
Mortgage REITs are leveraged investment companies that buy and sell loans and other real-estate-related securities. Unlike most other REITs, mortgage REITs borrow to buy mortgages, which magnifies the returns. [Mortgage REIT ETFs: Double-Digit Yields and Risks]
“Mortgage REITs, not to be confused with equity REITs, borrow money to buy mortgage-backed securities, particularly federally guaranteed securities from Freddie Mac and Fannie Mae,” according to Morningstar analyst Abby Woodham. “Their profit comes from the spread between the short-term financing used to buy the higher-yielding mortgage-backed securities. Mortgage REITs do not have access to deposit funding, so they rely on short-term loans like repurchase agreements.”
If the companies buy “nonagency” loans, then investors are subject to defaults and potential losses. Investors have to have a strong conviction that both the housing market, real estate market and economy are growing. On the flip side, the added risk translates to higher yields.
However, interest rates are a significant risk ahead. Since mortgage REITs borrow to purchases mortgages, rising interest rates would eat away at capital returns and cause some funds to lower dividend yields.
Mortgage REIT nvestors have enjoyed hefty paydays since the REIT companies don’t pay income taxes as long as they distribute 90% of net income as dividends. Since the REIT structure passes on most of its earnings, along with taxes, on to shareholders, potential investors should be aware that most REITs are taxed as income, not as qualified dividends.
Investors who are interested in mortgage REITs can take a look at two ETF options: the iShares FTSE NAREIT Mortgage Plus Capped Index Fund (NYSEArca: REM) and Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT).