How to Invest in mREITs

By Dan Caplinger Markets Fool.com

Investing in mREITs is a tempting proposition for those who like high dividend yields, because the real estate investment trusts that specialize in owning mortgage-backed securities tend to use leverage to amplify their income. With that leverage comes risk, however, and it's important to understand exactly what you're getting into when you buy an mREIT. In particular, investors should keep the following things in mind when assessing mortgage real estate investment trusts:

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  • Which types of mortgage-backed securities the mREIT invests in
  • How much leverage the mREIT takes on
  • How the mREIT raises capital
  • What the mREIT's book value is compared to its share price

What mortgage-backed securities does the mREIT own?

To make its operational investing easier, mortgage REITs typically own mortgage-backed securities rather than investing in individual mortgages. The market for many mortgage-backed securities is fairly liquid, allowing mREITs to trade securities freely during most market conditions.

However, mortgage-backed securities, or MBSs for short, come in two broad categories. Agency MBSs are issued by government agencies or government-sponsored entities such as Fannie Mae and Freddie Mac. The market for agency MBSs is the most liquid in the mortgage realm, and financing is more readily available for such securities. That allows mREITs that specialize in agency MBSs to take on greater leverage.

Image source: Getty Images.

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By contrast, non-agency MBSs include all securities that don't come from those government sources. The market for such securities is less liquid, and mREITs that use them tend to have lower levels of leverage. Many see the risk of non-agency MBSs as getting balanced out by those lower leverage levels.

Some mREITs, such asAnnaly Capital Management(NYSE: NLY), use a hybrid approach that involves combining different strategies. Regardless of which strategy your mREIT uses, you should look closely at its portfolio to determine where it is on the asset spectrum.

How much leverage does the mREIT use?

As mentioned above, the other key aspect of risk in an mREIT is its leverage ratio, or ratio of total assets to shareholder equity on the balance sheet. With mREITs that specialize in agency MBSs, it's not uncommon to see leverage ratios of five to 10. Those that typically buy non-agency MBSs will usually have lower leverage ratios but still take extensive advantage of financing opportunities.

The higher the leverage, the greater the potential profit from favorable industry conditions. However, when the MBS market starts to deteriorate, higher leverage creates greater potential for losses as well. Watching not only current leverage ratios but also how much those leverage levels change in response to shifts in the interest rate environment can give you insight into how a particular mREIT is being managed.

How does the mREIT raise capital?

There's only so much leverage that an mREIT can have. In order to grow, mortgage REITs have to find equity capital that they can then use as collateral to boost their financing. That equity capital often comes from secondary stock offerings, and it's important that mREITs conduct these offerings in a way that minimizes the potential dilution of existing shareholders' interest.

As you'll see below, issuing shares below the net asset value of the underlying assets of the mREIT is more likely to result in dilution than issuing shares at a price higher than net asset value. By seeing how an mREIT has made such moves in the past, you can see how aware of shareholder interests it is and whether management will protect your stake going forward.

What's the mREIT's net asset value?

Net asset value is a simple concept, involving putting a value on the MBSs and other investments held by the mREIT and then subtracting existing liabilities such as outstanding debt. The resulting figure is divided by the number of shares outstanding to determine a net asset value per share.

Some mREITs will trade at a premium to their net asset value, while others will trade at a discount. In addition, changing market conditions will have an impact on where an mREIT's shares trade compared to net asset value. When you've become familiar with particular mREITs, you'll be better able to identify unusual conditions when they arise and take advantage of them.

Investing in mREITs involves getting familiar with some complicated concepts you won't find elsewhere in the stock market. However, with the potential for huge dividend yields, many investors find mREITs worth the effort to get to know and include in their portfolios.

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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.