A real estate investment trust, or REIT, is a special type of corporation. Its primary business is investing in real estate and related assets. To be classified as a REIT, a corporation needs to meet a few basic criteria. REITs must
- invest at least 75% of assets into real estate or related assets,
- derive at least 75% of their income from real estate sources,
- have at least 100 shareholders,
- be no more than 50% owned by five shareholders, and
- pay out at least 90% of their taxable income to shareholders as dividends.
If it meets these requirements and a few more, a REIT enjoys a nice tax advantage: It pays zero corporate tax on its profits. REITs are pass-through entities, similar in tax treatment to a partnership or LLC.
With most dividend-paying stocks, profits are effectively taxed twice. Once when they are earned (corporate tax), and again when they’re paid out to shareholders (dividend tax). REIT profits are only taxed on the individual level. And if they’re held in a tax-advantaged retirement account, investors don’t have to worry about paying taxes on their dividends at all.
What is a mortgage REIT?
When it comes to REITs, there are two main categories -- equity REITs and mortgage REITs (also known as mREITs). Equity REITs are what most people think of when they hear the term "real estate investment trust." These companies own, manage, and develop commercial properties.
Mortgage REITs invest in mortgages, mortgage-backed securities, and related assets. According to Nareit, mortgage REITs help finance 1.8 million homes in the United States. As you might imagine, this is quite a different business than owning properties. In fact, mortgage REITs aren’t even classified in the real estate sector -- they're considered financial stocks.
The mortgage REIT business is complex and REITs take different approaches. But in general, they use large amounts of debt to profit from the difference between the rates paid by mortgages and short-term borrowing rates.
If a mortgage REIT can borrow money at 3% interest to buy mortgages that pay 4.5% interest, the 1.5% difference is the profit margin. Most investors aren’t interested in a yield of 1.5%, so these companies use lots of borrowed money to maximize profits.
Let’s say that a mortgage REIT has $2 billion in investor capital. In addition to this amount, it borrows $10 billion at 3% interest to buy mortgages, which pay interest rates of 4.5% on average. This company would own $12 billion worth of mortgages paying a total of $540 million in interest annually (4.5% of $12 billion). The REIT would pay $300 million in interest on its debt for a total annual income of $240 million. This is a 12% return on the $2 billion in investor capital.
That's a very simple example. Several other factors determine mortgage REIT profits, and we’ll get into some of them in the next section. This simply illustrates why mortgage REITs tend to pay such high dividend yields.
It’s also important to mention that mortgage REITs are intended solely as income investments. In other words, mortgage REITs don’t invest in assets because they think they’ll go up in value. They're primarily focused on generating income.
Risks of investing in mortgage REITs
Individual business models vary, but interest rates are typically the biggest risk to investing in mortgage REITs.
These companies borrow money at lower short-term rates to buy mortgages, which generally have terms of 15 or 30 years. This works if short-term interest rates stay the same or drop. But if short-term borrowing rates go up, mortgage REITs’ profit margins can erode fast.