Mortgage REITs (mREITS) purchase or originate mortgages and mortgage-backed securities (MBS) and earn income from the interest on these investments to fund income-producing real estate.
Are mortgage REITs good?
When the spread between short-term and long-term interest rates (where they borrow) is substantial, mREITs can produce a significant net interest margin (where they lend). Unfortunately, the spread rarely remains broad for long, which makes mREITs extremely volatile. Because of this risk, mREITs aren’t always the best choice for income-seekers, as their high yields fluctuate drastically. A few fascinating mREITs, on the other hand, are worth investigating since their differentiated business strategies help buffer them from the sector’s overall volatility.
What are the risks of mortgage REITs?
Individual company strategies differ, but the riskiest aspect of investing in mortgage REITs is usually interest rates.
These businesses borrow money at cheaper short-term rates in order to purchase mortgages with periods of 15 or 30 years. If short-term interest rates stay the same or fall, this strategy works. However, if short-term borrowing rates rise, mortgage REIT profit margins could quickly collapse.
Do mortgage REITs go down when interest rates go up?
Because the value of a mortgage bond is inversely proportional to interest rates (higher rates cause mortgage bond values to fall), higher rates will cause the NAV of a mortgage REIT to fall, and the share price will often follow.
Equity REITs
The most popular are equity REITs. They own and manage properties, and the majority are specialized, which means they only invest in certain types of real estate.
- Retail area in big-box stores (a shopping center featuring at least one big store like Best Buy or Home Depot)
- They make the greatest money collecting rent from renters on their own property.
- Appreciation: As the value of the property increases, so does the value of the shareholders’ investments.
Mortgage REITs
Mortgage REITs borrow money at short-term rates in order to buy mortgages with higher long-term rates. The benefit comes from the difference in interest rates. Mortgage REITs often use a lot of leverage to optimize returns—up to $5 in debt for every $1 in cash, and sometimes even more.
Mortgage REITs borrow money at short-term rates in order to buy mortgages with higher long-term rates. The benefit comes from the difference in interest rates.
Okay, this is getting complicated, so let’s try to simplify it with numbers. Assume a mortgage REIT raises $1 million in capital. It then takes out a $5 million loan at a 2% short-term interest rate. This means it will have to pay back $100,000 in annual expenses. However, it uses the $6 million in cash it now possesses to purchase a number of mortgages at a 4% interest rate, generating $200,000 in interest revenue for the REIT. The profit is the difference ($100,000 in our example).
Because you’re smart, you’re probably wondering what will happen if the short-term interest rate rises.
Any increase in the short-term interest rate reduces the profit—in our example, if it doubled, there would be no profit left. If it rises significantly higher, the REIT will lose money. Mortgage REITs are exceedingly volatile as a result of all of this, and their payouts are also extremely unpredictable.
Non-Traded REITs
Some REITs are no longer traded on major stock exchanges. Although non-traded REITs are still registered with the Securities and Exchange Commission (SEC), they are not eligible for trading on the stock exchange. A significant concern here is that determining the worth of a non-traded REIT until years after you’ve invested might be difficult. 4 So, if it turns out to be a dud, you won’t know for a long time—yikes!
Private REITs
A private REIT is not registered with the Securities and Exchange Commission (SEC) and is not eligible for trading on stock exchanges. 5 If you buy one, be prepared to forget about the money you spent on it. They’re frequently illiquid, which is a fancy way of saying that an investment can’t be quickly converted to cash. You won’t have access to the money for a long time in order to achieve the highest returns. It’s incredibly tough to get out of a private REIT once you’re in one because of this. It isn’t as straightforward as selling a mutual fund.
To make a private REIT work for you, you’d have to be part of a group that isn’t milking the REIT for profit and driving up management costs, leaving investors with nothing. Beware! This is high-risk territory.
Why do mortgage REITs pay high dividends?
Residential mortgage loans or pools of mortgage loans generated by qualifying financial institutions are purchased by these organizations. To be purchased, the mortgages must meet particular lending standards and other factors.
These mortgages are packaged by Fannie Mae, Freddie Mac, and Ginnie Mae into agency mortgage-backed securities, or MBS. Because the principal and interest paid by homeowners are passed on to the holders of mortgage-backed securities, these bonds are referred to as “pass-through securities.” The payment of the principal and interest on the mortgages that make up the agency mortgage-backed securities is guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae.
According to sifma, there were $8.1 trillion in outstanding US agency mortgage-backed securities as of September 30, 2020.
Fannie Mae, Freddie Mac, and Ginnie Mae all issue interest-bearing bonds known as agency securities in addition to mortgage-backed securities. The proceeds from these bonds are used to fund the agencies’ operations as well as to purchase mortgages that are later included in mortgage-backed securities.
Investors presume the US government will guarantee the performance of these bonds if Fannie Mae, Freddie Mac, or Ginnie Mae run into financial difficulties, therefore these three agencies can issue debt at extremely low yields. During the Great Financial Crisis of 2008 and 2009, this assumption proved right, as the US government did indeed offer financial support to these organizations, preventing their bonds from defaulting.
Non-Agency Mortgage-backed Securities
Non-agency mortgage-backed securities are also packaged by private issuers from pools of mortgages. To protect holders from defaults on the underlying mortgages, non-agency mortgage-backed securities may include insurance or other credit enhancements.
According to sifma, there were $1.3 trillion in non-agency mortgage-backed securities outstanding as of September 30, 2020.
Why REITs are bad investments?
Real estate investment trusts (REITs) are not for everyone. This is the section for you if you’re wondering why REITs are a bad investment for you.
The major disadvantage of REITs is that they don’t provide much in the way of capital appreciation. This is because REITs must return 90 percent of their taxable income to investors, limiting their capacity to reinvest in properties to increase their value or acquire new holdings.
Another disadvantage is that REITs have very expensive management and transaction costs due to their structure.
REITs have also become increasingly connected with the larger stock market over time. As a result, one of the previous advantages has faded in value as your portfolio becomes more vulnerable to market fluctuations.
Are mortgage REIT dividends qualified?
Because most stock dividends fall under the IRS’s definition of “qualified dividends,” they are subject to lower long-term capital gains tax rates. The majority of REIT distributions aren’t eligible.
As a result, the bulk of REIT dividends are treated as regular income and are taxed at your marginal rate.
Some of your REIT distributions, on the other hand, may qualify as eligible dividends. When a REIT distributes a long-term capital gain on the sale of an asset or gets a qualified dividend payment, this occurs.
Is ABR a mREIT?
Arbor Realty Trust (ABR) is a mostly self-managed Agency mREIT with two primary business divisions (Structured Business and Agency Business). The company’s assets in the Structured Business division are structured finance assets in the multifamily market.
How often do REITs fail?
Historically, buying REITs following a market crisis has always been a smart move, and we have little doubt that this time will be no different. REITs, on the other hand, aren’t “ideal investments.” In truth, there are numerous ways for a REIT investor to lose money. Over the last 20 years, REITs have returned 15% a year, according to NAREIT.
What is the difference between equity REITs and mortgage REITs?
Equity REITs own and run properties, and their primary source of revenue is rental income. Mortgage REITs make investments in mortgages, mortgage-backed securities, and similar assets, and earn money through interest payments.
What does Dave Ramsey say about REITs?
Do you want to know more details? Here’s a rundown of some typical investment possibilities, as well as Dave’s thoughts on them—both positive and negative.
Mutual Funds
Mutual funds allow you to invest in a variety of businesses at once, ranging from the largest and most stable to the newest and fastest-growing. They have teams of managers who, depending on the fund type, select companies for the fund to invest in.
So, why does Dave propose this as the only investing option? Dave prefers mutual funds because they allow him to diversify his investment across a number of companies, avoiding the risks associated with single stocks like Dogecoin. Mutual funds are an excellent alternative for long-term investing since they are actively managed by professionals who strive to identify stocks that will outperform the stock market.
Exchange-Traded Funds
ETFs are collections of single stocks that are designed to be traded on stock exchanges. ETFs do not employ teams of managers to select firms for investment, which keeps their fees cheap.
Because ETFs allow you to swap investments quickly and easily, many people try to play the market by buying cheap and selling high, but this is extremely difficult to do. Dave favors a buy-and-hold strategy, which entails holding on to investments over time and maintaining a long-term perspective rather than selling on the spur of the moment when the market falls.
Single Stocks
Your investment in a single stock is contingent on the performance of that firm.
Dave advises against buying single stocks since it’s like putting all your eggs in one basket, which is a large risk to take with money you’re dependent on for your future. If that company goes bankrupt, your savings will be lost as well. No, thank you!
Certificates of Deposit (CDs)
A certificate of deposit (CD) is a form of savings account that allows you to store money for a predetermined period of time at a fixed interest rate. Withdrawing money from a CD before its maturity date incurs a penalty from the bank.
CDs, like money market and savings accounts, have low interest rates that do not keep pace with inflation, which is why Dave advises against them. While CDs are helpful for putting money down for a short-term purpose, they aren’t suitable for long-term financial goals of more than five years.
Bonds
Bonds are a type of debt instrument that allows firms or governments to borrow money from you. Your investment earns a predetermined rate of interest, and the company or government repays the debt when the bond matures (aka the date when they have to pay it back to you). Bonds, like stocks and mutual funds, rise and fall in value, although they have a reputation for being “safe” investments due to less market volatility.
However, when comparing investments over time, the bond market underperforms the stock market. Earning a set interest rate will protect you in poor years, but it will also prevent you from profiting in good years. The value of your bond decreases when interest rates rise.
Fixed Annuities
Fixed annuities are complicated plans issued by insurance firms that are designed to provide a guaranteed income in retirement for a specific period of years.
Dave doesn’t advocate annuities since they can be costly and come with penalties if you need to access your money during a set period of time. You might be wondering what a designated surrender period is. That’s the amount of time an investor must wait before being able to withdraw funds without incurring a penalty.
Variable Annuities (VAs)
VAs are insurance products that can provide a steady stream of income and a death payment (money paid to the beneficiary when the owner of the annuity passes away).
While VAs provide an additional tax-deferred retirement savings option for those who have already maxed out their 401(k) and IRA accounts, you lose a much of the growth potential that comes with mutual fund investing in the stock market. Furthermore, fees can be costly, and VAs impose surrender charges (a penalty price you must pay if you withdraw funds within the surrender period).
Real Estate Investment Trusts (REITs)
REITs are real estate investment trusts that own or finance real estate. REITs, like mutual funds, sell shares to investors who want to share in the profits generated by the company’s real estate holdings.
Dave enjoys real estate investing, but he prefers to invest in cash-flowing properties rather than REITs.
Cash Value or Whole Life Insurance
Whole life insurance, often known as cash value insurance, is more expensive than term life insurance but lasts your entire life. It’s a form of life insurance product that’s frequently promoted as a means to save money. That’s because insurance is also attempting to function as an investing account. When you get whole life insurance, a portion of your “investment” goes into a savings account within the policy.
Sure, it may appear to be a nice idea at first, but it is not. The kicker is that when the insured person dies, the beneficiary receives only the face value of the insurance and loses any money that was saved under it (yes, it’s pretty stupid).
Dave only advises term life insurance (life insurance that protects you for a specific length of time, such as 15–20 years) with coverage equivalent to 10–12 times your annual income. If something occurs to you, your salary will be compensated for your family. Don’t know how much insurance you’ll need? You can use our term life calculator to crunch the numbers.
Separate Account Managers (SAMs)
SAMs are third-party investment professionals who purchase and sell stocks or mutual funds on your behalf.
Simply say, “No thanks, Sam,” to this option. Dave chooses to put his money into mutual funds that have their own teams of competent fund managers with a track record of outperforming the market.
Can you lose money in REITs?
- REITs (real estate investment trusts) are common financial entities that pay dividends to their shareholders.
- One disadvantage of non-traded REITs (those that aren’t traded on a stock exchange) is that investors may find it difficult to investigate them.
- Investors find it difficult to sell non-traded REITs because they have low liquidity.
- When interest rates rise, investment capital often flows into bonds, putting publically traded REITs at danger of losing value.
