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Mortgage REITs, which are a relatively small part of the REIT market, have developed somewhat of a cult following lately among income-seeking investors with an appetite for risk. The high yields and low prices are attracting a swarm of new buyers, hoping to leverage the power of compounding interest over time by getting in at these low levels. Critics of mortgage REITs are singing a different tune, saying that the dividends are unsustainable, and that rising interest rates will crush the profitability of these investments over the coming years. Let's take a closer look at the largest and most widely followed of these, Annaly Capital Management (NYSE:NLY), to see exactly what investors are getting into here, and if there might be a safer way to play it.

Annaly: biggest and most followed

Annaly is a pass-through mortgage REIT that owns and manages a portfolio of agency mortgage-backed securities. The way Annaly, and companies like it, generate high levels of income for their shareholders is from the spread between the interest income generated by the mortgage-backed securities and the cost of borrowing money to finance the purchase of those securities.

So, the company's income level is extremely sensitive to interest rates. As rates rise, the company's borrowing costs increase, while the yields on the securities they already own stay the same (about 93% of Annaly's portfolio is fixed-rate securities). As a result, the company's interest margins have narrowed considerably over the past few years, and Annaly's quarterly dividend has fallen by about 53% since its peak in 2010.

Does diversifying help?

Perhaps instead of investing in just one of the mortgage REITs, whose dividends and profitability are not incredibly stable, is not the best way to go. There is an REIT called Market Vectors Mortgage REIT ETF (NYSEARCA:MORT) that tracks the performance of a weighted index of the mortgage REITs. Largest holdings of the fund include Annaly (about 16% of holdings), American Capital (NASDAQ:ACAS), Starwood Property Trust (NYSE:STWD), Chimera Investment Corp. (NYSE:CIM), and many other smaller holdings.

As the ETF functions as a pass-through, it has no real control over the distributions to its shareholders. This fund pays a quarterly distribution, and dividends have dropped significantly in the two years or so the fund has been in existence, but not as drastically as some of the individual names, such as Annaly.

So, while the dividends of the mortgage REITs tend to rise and fall as one collective group, investing in the index ETF buys you a little bit of downside protection if any one of the holdings had to dramatically slash its payout for whatever reason.

Double down?

As if these things weren't paying out enough as it is, there is a leveraged ETF from UBS called the ETRACS Monthly Pay 2x Leveraged Mortgage REIT (NYSEARCA:MORL) that essentially doubles your investment (and payout) in the mortgage REIT index. The fund is allocated in the same percentages as the other ETF mentioned, and in theory should pay out twice as much.

The dividends of both of these ETFs are somewhat erratic, since the ETF simply passes along the dividends of the underlying REITs. Some of these are on a monthly pay schedule, while most are on a quarterly dividend schedule. Therefore, ever third month the ETFs pay out a large dividend, and in the "in-between" months, a smaller payout (about 5% on an annualized basis for the leveraged ETF) is given to investors.

For example, the fund just declared a $0.7938 payment for October (the large, quarterly payment), after payments of $0.1062 and $0.0884 in August and September, respectively. These are down by about 28% from last quarter, which makes sense because it's about twice the rate as the yields of the index have been declining.

Summary

With relatively low expenses and the peace of mind that comes with diversification, the ETF route definitely seems to be the way to go in regards to mortgage REITs. The leveraged version is certainly not for the faint of heart, but if things go well for the underlying funds, could prove to be a very lucrative investment for those willing to take the chance. For those with a more normal level of risk tolerance, however, the index ETF will do just fine, and pay handsomely enough.

Source: The 'Safer' Way To Play Mortgage REITs?