The popularity of levered mortgage real estate investment trusts (REITs) will not stand the test of time. Over the next few decades, levered mortgage REITs will be viewed as oddities peculiar to an era with artificially low short-term interest rates. It is likely that they will join the list of once-popular investment strategies, such as holding precarious subprime collateralized debt obligations or the practice of day trading dot-com stocks. Investors should only purchase levered mortgage REITs to replace a fraction of their fixed-income allocation inside of a tax-advantaged account.
How mREITs Work
These REITs take levered positions in mortgage notes. They buy mortgage loans and then use those loans as collateral to buy more mortgages, and then repeat this buying and borrowing process multiple times. The net effect is that these trusts purchase multiple times their value in mortgage loans on margin.
Currently, these positions are attractive because mortgage yields are higher than short-term interest rates. By borrowing short and lending long, these REITs exploit the spread between low short-term interest rates and higher long-term mortgage rates. They further exploit this spread by buying multiple times the value of the fund, allowing them to reap multiple times the spread.
As REITs, they must then distribute at least 90% of income from their holdings. Fixed-income investors are attracted to these levered mortgage REITs because of their high dividend payouts.These high dividend yields are hard for fixed-income investors to resist, especially in today’s low interest rate environment.To continue reading, click here.