In this post, we will cover the topic of mortgage REITs, but first, here is our disclosure.
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First Things First: What is a REIT?
A REIT stands for Real Estate Investment Trust.
In short, a REIT is a company that owns, operates, or finances income-generating property.
REITs can be private or public companies. There are pros and cons to owning both, with one of the most significant differences being that publicly traded REITs can be listed on major exchanges. These publicly listed REITs are a popular way to invest in real estate. They eliminate the need to physically own and operate real estate while allowing you to buy and sell them like any other stock.
There are several requirements that a company needs to meet to operate as a REIT. The big one that attracts many investors is that a REIT must pay out a minimum of 90% of its taxable income to shareholders through dividends. REITs tend to have higher dividend yields because of this required payout, making REITs a solid option for people looking for passive income from dividends.
REITs can take a focused or broad approach to the types of properties they own. For example, some might concentrate on leasing properties associated with healthcare, while other REITs may own and lease large warehouses or retail spaces. Other REITs may decide to hold a diverse real estate portfolio across industries and even countries.
A smaller subset of REITs own no real estate at all, and their primary focus is on financing real estate. These are known as mortgage REITs or mREITs for short.
Mortgage REITs
How Do They Work?
Mortgage REITs (mREITs) concentrate on the financing of income-generating properties. These types of REITs are centered on both residential and commercial mortgages. Mortgage REITs earn revenue from the interest received by purchasing and issuing mortgages and mortgage-backed securities.
Their level of profit is determined by the margin, or spread, between the interest they receive from their mortgage holdings and the cost they pay to service their debt.
What are the Risks of Investing in Mortgage REITs?
There are several risks associated with owning mortgage REITs, the biggest being interest rate risk.
Mortgage REITs borrow money to purchase mortgages and mortgage-backed securities. When interest rates are high, their borrowing costs increase, resulting in a smaller margin between the interest they earn on their mortgage holdings and the interest they pay on the debt.
Interest rates will also determine the rate of refinancing, leading to a changing landscape of the length of mortgages in the mREITs’ holdings.
What About Dividends
Some of your highest-paying dividend companies are mortgage REITs. The high dividend rate makes mortgage REITs an enticing investment. The three mREITs I mention later in this post all have dividends of over 10%.
Sound too good to be true? It can be.
High-interest rates will hurt mortgage REITs’ financials, leading them to take on more debt to service their large dividends. Ultimately, this can lead to dividend cuts, which is not uncommon for mortgage REITs.
A Comment on Beta and Mortgage REITs
Beta measures the volatility of a stock relative to the market. A stock with a beta of less than 1 is less volatile than the market, and if the beta is greater than 1, it is more volatile than the market.
For example, a stock with a beta of 3 would be three times more volatile than the market. But if a stock you were researching had a beta of 0.5, it would be half as volatile as the market. You can think of it like a roller coaster ride.
That stock with a beta of 0.5 is like a kiddie roll coaster ride. Sure, you will have some ups and downs but not too many or too big. By the end of the ride, it was a little exciting, but your stomach felt fine.
A stock with a beta of 1 is like your typical roller coaster. It will have some big ups and downs, but you will have fun without getting too scared. You would get back in line to ride it again.
Now, what about that stock that had a beta of 3? It would be more like that monster roller coaster with a huge drop followed by a loop-the-loop and corkscrew. When it is over, your adrenaline is pumping, and you feel a little sick. Only the bravest among us would go back for more.
What Does Beta Have to Do With Mortgage REITs?
Dividend investors typically look for established companies with long and stable track records of paying dividends. These companies tend to be less volatile than the overall market, with a beta of less than 1. They have dividends typically in the 2% to 5% range. Think big, “boring” companies like Johnson and Johnson, Coca Cola and Proctor and Gamble.
The same is true for many large equity REITs like Reality Income Corp, W.P. Carey Corp, or National Retail Properties. However, this is not the case for mortgage REITs.
It is common for mortgage REITs to have betas greater than 1 and dividend payouts that approach and exceed double digits. This makes them attractive for investors chasing higher dividend yields, but with sky-high dividends come greater volatility and risk.
Why I Decided to Take a Chance On Mortgage REITs
At the start of 2022, the market began its steady descent. This downward trend had me searching for investments that can provide a decent rate of return through interest and dividends. I settled on a couple of options, one being I bonds and the other being REITs. I would place these investments as a satellite in my core-satellite investment portfolio.
As I was researching REITs, I stumbled upon mortgage REITs. Their dividends were some of the highest I have seen. I learned about their downsides and knew the risk I would take if I decided to invest in mREITs. Yet, I thought I could get in low while receiving high dividend yields.
The mortgage REITs I reviewed were down big due to high inflation and interest rates. I was taking a gamble that the environment should start to get better for mREITs as we approached 2023. If I hold my mortgage REIT positions long-term, I might profit from rising stock prices and big dividends.
With these pros and cons in mind, I decided to take a chance on mortgage REITs.
My Investment Strategy for Mortgage REITs
Before purchasing mortgage REITs, I had to devise a game plan for approaching this investment.
I decided to keep my total investment in mortgage REITs very small at less than 1% of my portfolio. I would buy shares close to their 52-week lows and reinvest the dividends.
Ultimately, considering the risks and my limited experience with mortgage REITs, I thought this was my best approach.
My Choice of Mortgage REITs
After researching my options for mortgage REITs, I decided to purchase shares in AGNC Investment Corp (NASDAQ: AGNC), Annaly Capital Management (NYSE: NYL), and Ready Capital Corp (NYSE: RC).
AGNC Investment Corp
Dividend Yield: >10%
Dividend Payout Frequency: Monthly
Primary Investment: Mortgage-backed securities that are guaranteed by the US government
Stock Exchange: NASDAQ
Stock Ticker: AGNC
Website: agnc.com
2022 Returns: AGNC ended down more than 30%
Why I Chose AGNC Investment Corp
I liked AGNC Investment Corp because it primarily invests in mortgage-backed securities that are guaranteed by the US government. Investing in securities backed by the US government provides some level of safety by keeping credit risk low.
Another positive was that AGNC is one of the largest mortgage REITs with a market cap of around $6 billion and has been around for over a decade. This meant I was investing in a company with significant experience and time in the mortgage REIT industry.
What Are the Risks of investing in AGNC?
Right now, the US government is increasing interest rates and reducing its holdings in mortgage-backed securities through quantitative tightening. This leads to an increase in mortgage-backed securities hitting the market, which lowers their value and drives up their yield. This hurts mortgage REITs, like AGNC, that focus on mortgage-backed securities, leading to weak earnings and the potential for dividend rate cuts.
Annaly Capital Management
Dividend Yield: >10%
Dividend Payout Frequency: Quarterly
Primary Investment: Mortgage-backed securities guaranteed by the US government
Stock Exchange: NYSE
Stock Ticker: NLY
Website: annaly.com
2022 Returns: Annaly Capital ended down more than 30%
Why I Chose Annaly Capital Management
My reasons for investing in Annaly Capital Corp are almost a carbon copy of AGNC Investment Corp. Like AGNC; they invest primarily in agency mortgage-backed securities guaranteed by the US government.
Annaly Capital has been around for over two decades and is one of the largest mortgage REITs having a market cap of over $10 billion. This means Annaly Capital has significant time and experience as a mortgage REIT, just like AGNC.
What are the Risks of investing in Annaly?
You guessed it. The risks associated with Annaly are similar to the ones faced by AGNC: high-interest rates and quantitative tightening. Both can lead to a weakness in earnings and the need for dividend cuts.
Ready Capital Corp
Dividend Yield: >10%
Dividend Payout Frequency: Quarterly
Primary Investment: Non-bank lender for real estate and small businesses. It is both SBL and SBA-approved.
Stock Exchange: NYSE
Stock Ticker: RC
Website: readycapital.com
2022 Returns: Ready Capital ended down more than 30%
Why I Chose Ready Capital
Both AGNC and Annaly Capital primarily invest in agency mortgage-backed securities. I wanted to diversify my mortgage REIT holdings to include one focused on loans. It is here that I settled on Ready Capital Corp.
Ready Capital focuses on acquiring, financing, originating, and servicing small to medium-sized commercial loans. Ready Capital isn’t limited to only issuing real estate loans. They are a non-bank leander to both real estate and small businesses, specializing in commercial real estate-backed loans and government-backed business loans. This diversity in its loan type was a big draw.
I also liked that many of the loans that Ready Capital issues are first-lien loans and floating-rate loans. These aspects of their loans could help reduce the risks associated with higher interest rates and nonpayment.
What are the Risks of investing in Ready Capital?
Ready Capital directly finances real estate and directly issues loans, and therefore, it carries risks like any other mortgage REIT including rising interest rates and loan defaults.
If the economy sours in 2023, as some economists predict, then Ready Capital can be looking at an increase in loan defaults and a problem with liquidity.
Final Thoughts
Risk, Risk, and More Risk
Always remember that investing involves risk, and you may lose money. Investing in mortgage REITs is no exception to this rule.
Mortgage REITs are unlike your typical equity REIT that owns and operates properties. Instead, mortgage REITs deal in real estate financing, and their business model means they are highly leveraged businesses. You should not invest in mortgage REITs without thorough research. If necessary, consult a competent financial professional.
The bottom line is that mortgage REITs offer a very enticing dividend, but it comes with high risk and volatility.
Have My Investments Been Successful?
By investing in AGNC, Annaly Capital, and Ready Capital, I had hoped to capitalize on the high dividend yield while trying to minimize the risk associated with mortgage REITs. As of this writing, it is too early to tell if I have succeeded, but my holdings have performed as expected.
In 2022 all three underperformed the S&P 500 and Dow Jones and closed the year down over 30%, but my investments in these three mREITs did not have similar losses.
I bought AGNC, Annaly Capital, and Ready Capital closer to their 52-week lows and have been reinvesting their dividends. The result is both my stakes in AGNC and Annaly Capital were down only 5%-6% in 2022, and my stake in Ready Capital almost matched the S&P 500, closing down 20%.
I look forward to seeing how these investments perform in 2023 and if they can sustain their high dividends. I will provide updates as 2023 moves along.
