Investors have been attracted to ETFs tracking real estate investment trusts for their high yields and outperformance relative to the S&P 500 in recent years. Within the sector, mortgage REITs generate the highest yields, but they are not without their risks.
Mortgage REITs are leveraged investment companies that buy and sell loans and other real-estate-related securities. Unlike most other REITs, mortgage REITs borrow to buy mortgages, which magnifies the returns.
"Mortgage REITs, not to be confused with equity REITs, borrow money to buy mortgage-backed securities, particularly federally guaranteed securities from Freddie Mac and Fannie Mae," according to Morningstar analyst Abby Woodham. "Their profit comes from the spread between the short-term financing used to buy the higher-yielding mortgage-backed securities. Mortgage REITs do not have access to deposit funding, so they rely on short-term loans like repurchase agreements."
If the companies buy "nonagency" loans, then investors are subject to defaults and potential losses. Investors have to have a strong conviction that both the housing market, real estate market and economy are growing. On the flip side, the added risk translates to higher yields.
However, interest rates are a significant risk ahead. Since mortgage REITs borrow to purchases mortgages, rising interest rates would eat away at capital returns and cause some funds to lower dividend yields.
Mortgage REIT investors have enjoyed hefty paydays since the REIT companies don't pay income taxes as long as they distribute 90% of net income as dividends. Since the REIT structure passes on most of its earnings, along with taxes, on to shareholders, potential investors should be aware that most REITs are taxed as income, not as qualified dividends.
Investors who are interested in mortgage REITs can take a look at two ETF options: the iShares FTSE NAREIT Mortgage Plus Capped Index Fund (NYSEARCA:REM) and Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT).
The iShares REM tries to reflect the performance of the FTSE NAREIT All Mortgage Capped Index. REM has a 11.15% 12-month yield and 0.48% expense ratio. The ETF is up 17.6% year-to-date.
The fund has 30 holdings and the top ten make up 73.2% of the overall portfolio. Top holdings include Annaly Capital Management 20.9%, American Capital Agency 17.6%, Starwood Property Trust 6.2%, Two Harbors Investment 4.6% and Chimera Investment 4.5%.
Annaly and American Capital make up a significant portion of mortgage REITs. The companies invest in agency-backed mortgages.
The Market Vectors MORT tries to reflect the performance of the Market Vectors Global Mortgage REITs Index. MORT has a 8.22% distribution yield and a 0.40% expense ratio. The fund is up 17.6% year-to-date.
The ETF has 26 holdings and the top ten make up 69.1% of the overall portfolio. Top holdings include Annaly Capital 16.5%, American Capital Agency 14.7%, Chimera Investment Corp 5.3%, Mfa Financial 5.0% and Starwood Property Trust 4.9%.
Max Chen contributed to this article.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.