Stock & Options Trading

What Is Mortgage REIT?

Morningstar's analyst Erin Swanson masterfully explained what is Mortgage REIT, and why it is not a timely bet in today's market. I invested in one of the Mortgage REIT before (which later merged with an investment firm to today's Friedman, Billings, Ramsey Group - FBR) with some good gains, but that's back in 2003.

Generally speaking, a REIT is a company that invests in income-producing real estate assets--at least 75% of total assets--and distributes a minimum of 90% of its income as dividends. In fact, many REITs distribute 100% of income to avoid corporate taxes. Despite not being taxed at the corporate level, the majority of the dividend paid to shareholders is taxed as ordinary income, which is higher than the normal rate for dividend income. To understand the tax consequences of investing in REITs, we would suggest contacting your tax advisor.

More specifically, mortgage REITs represent a special segment of the REIT universe, owning little or no operating real estate. Instead, their assets are almost entirely real estate debt investments. Mortgage REITs profit on the spread between the rate at which they can borrow money and the interest rate at which they can lend the money to others. By borrowing against their portfolios, mortgage REITs purchase additional assets, increasing returns and risks to shareholders.

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Unfortunately, history has a way of repeating itself, and we fear that many of the risks that were present in the 1990s still exist today. We appreciate the fact that it is impossible to generate a sustainable return without taking on risk, but we caution that investors may get more risk than they bargained for in the current environment.

Interest rate risk continues to be a big stumbling block at several mortgages REITs that use short-term repurchase agreements to fund longer-term investment securities, a play that has paid off handsomely when interest rates decline. However, when interest rates increase and the yield curve is flat, companies face big problems. As several financial institutions will attest to, they are already feeling the pressure with regard to interest rates, as the yield curve has been flat for some time. In fact, Annaly Capital (NLY) -- a residential mortgage REIT--has been forced to cut its dividend several times over the past few years, from $0.50 per share in the fourth quarter of 2004 to $0.14 per share in the third quarter of 2006, because of the earnings pressure it has felt from a rising cost of funds.