How mortgage REITS work
Mortgage REITs provide financing for real estate by buying or originating mortgages and mortgage-backed securities, and then earning income from the interest on these investments. Some mortgage REITs focus on residential mortgages and mortgage-backed securities, while others focus on commercial mortgages and mortgage-backed securities. There are also mortgage REITs that hold both residential and commercial mortgages. When you invest in a mortgage REIT, you buy shares of that REIT, just as you'd purchase shares of a company's stock.
Mortgage REITs versus equity REITs
While mortgage REITs invest in and own mortgages, equity REITs acquire properties for the purpose of operating them to generate rental income. Mortgage REITs and equity REITs are similar in that both are required to distribute at least 90% of their income to shareholders, rather than retain that income for growth. Equity REITs are far more common than mortgage REITs, though mortgage REITs frequently offer higher dividend yields than equity REITs.
Benefits of investing in mortgage REITs
Mortgage REITs allow investors to diversify by making real estate investments without taking on the risk of owning actual property. Furthermore, because the IRS requires all REITs to distribute at least 90% of their income to investors, shareholders stand to make money in the form of dividends, whether they realize capital gains or not.
Drawbacks of investing in mortgage REITs
To be profitable, mortgage REITs must be able to prepare for and withstand changes in short-term and long-term interest rates. When interest rates rise, a mortgage REIT's holdings lose value, and the share price tends to drop. On the flip side, REITs can also lose value when interest rates fall and more mortgages are prepaid, thus limiting the amount of interest income REITs can generate. Some mortgage REITs may be exposed to higher credit risk if they purchase mortgages that aren't guaranteed by a federal agency. If those mortgages go into default, the REITs that hold them stand to lose money.
While investing in mortgage REITs can be rewarding, it's also risky. That said, publicly traded mortgage REITs are a far more liquid investment than actual property. If you're itching to get a piece of the real estate market without having to own property yourself, then you might consider adding a mortgage REIT to your investment portfolio.