At some point in building a wealth portfolio you may come across the option of purchasing mortgage REITs. Mortgage REITs can be an extremely powerful investment in real estate. These are highly risky investments that can sometimes produce a significant return on your overall investment portfolio. However, how much risk are you actually willing to take to get rewards that may never come? When building your portfolio how smart is the choice of adding mortgage REITs? To answer this you must first understand not only the basics of what a mortgage REIT is but also what the hazards involved really are.
Mortgage real estate investment trusts, or REITs, simply put are investments in residential mortgages that have been grouped together into a security known as a Mortgage Backed Security or MBS. The main difference between a regular REIT and a mortgage REIT is that a mortgage REIT owns no actual physical property. This is where the risk factor comes into play. You will then receive your income from payments that the borrowers make towards the mortgages that you own in your REIT package. Because of this Mortgage REITs are more similar in nature to bonds and therefore have more risk involved then regular real estate investments that are backed by actual property. There are two types of Mortgage REITs, called as the agency funded and non-agency. An agency REIT is backed by the government through either Freddie Mac, Fannie Mae which makes them creditworthy. Non-agency REITs are backed by investment banks. Non-agency debts hold more risk because they are less credit worthy and also less liquid, therefore if there is a default by the issuer, the holder of the loan is the one that is at a loss due to this.
Other risks involved include the fact that REITs do not allow for appreciation of collateral since there are no actual physical assets and they are in fact just instruments of debt. Interest rates cause significant fluctuations in dividends making them unstable and sometimes nonexistent. Due to their unpredictable nature the investor has to weigh how much they are willing to risk for a possible short term gain. Even in the best of circumstances, hefty payments that you may receive from a Mortgage REIT are not guaranteed and have the additional problem of being short lived.
When investing in Mortgage REITs one must also consider that if they are using a non-agency held bond the risk becomes even greater. The yields can also become much higher for the investor of a non-agency bond. Unless one is willing to deal with the inherent risks, it might be safer to go with an agency held bond. When using non-agency held bonds there is a certain amount of leverage that must be used. This leverage also increases the risk. By having to utilize leverage (such as the hazard of default), as well as deal with prepayment and interest rates an investor would be wise to understand and be well advised when weighing their options.