Mortgage REITs concentrate around property mortgages. These REITs loan money to investors in real estate – whether individuals, or companies. They do not own real estate properties, but generate income from the interests on the loans. They purchase mortgage-backed securities or existing mortgages. Mortgage REITs do not own property outright, but hold loans, or securities backed by real estate.

Mortgage REITs earn interest and fees charged on real estate loans, and generate substantial income for the investors. They distribute more than 90% of their earnings to avoid being taxed at the corporate level. 

The Need To Be Cautious

There are three major REITs: Equity REIT, Mortgage REIT, and Hybrid REIT, and they are not created alike. Mortgage REITs focus on commercial properties, though they do give loans for residential purposes. The brunt of recession leads to many offices going vacant, and there is a need for investors to be cautious when it comes to investing in mortgage REITs. They are great in an environment of falling interest rates, but can be dangerous when short-term rates rise dramatically. 

Mortgage REITs invest in securities backed by residential and commercial mortgage loans. The combination of the direction of the interest rates, and the failure of some to produce the expected returns, will cause many a heart to flutter. Though some mortgage REITs in recent times have yielded returns of 9% to 12%, there is still a need to be on the right side of caution. 

There are three basic types of mortgage REITs:

· The largest types are the ones based on asset size, and focus on investing in the highly rated, private-label residential mortgage backed securities (RMBS). They earn their money from the spread of interest rates. 

· The second types of mortgage REITs focus on bulk mortgages. Their operations are similar to the operations of mortgage banks, and the risk profiles of such mortgage REITs vary depending on the strategies they adopt.

· The last types of mortgage REITs invest in commercial mortgages, commercial mortgage backed securities (CMBS), etc. 

Some mortgage REITs target either adjustable rate or fixed rate residential mortgages. Now, many commercial mortgages are being packed into interest-rate-bearing CMBS (Commercial Mortgage-Backed Securities). Mortgage REITs that buy into CMBS, because of the nature of these securities, face different kinds of risks as it becomes very difficult to assess credit and interest-rate risks. Mortgage REITs for commercial properties include non-investment-grade portions of CMBS, along with a blend of mortgage loans. Prepayment penalties on some of these loans, against getting the principal back soon, are beneficial to investors, especially in the falling interest rate market. However, rising rates could have a reverse effect on the mortgage REITs investments. 

Mortgage REITs are volatile with uncertainties. More and more Mortgage REITs are investing in loans to existing buildings, rather than for construction and development. Most of the new mortgage REITs are now administered by professional managers, motivated purely by the fees, and the rewards for piling up assets.

Risks in Mortgage REITs

Mortgage REITs survive, rather flourish, in an environment of falling interest rates, but the market conditions can change rapidly. Many mortgage REITs have tried to mitigate their risks by reducing their exposure to interest rate volatility, by investing in adjustable-rate RMBS and loans. A look at some of the risks involved in mortgage REITs that include interest rates, funding and credit risks:

· Interest Rate Risk – These REITs invest in long-term mortgage assets with short-term variable-rate debt. When the short-term variable rates rise, they shrink the yield curve negatively. Disadvantageous interest rate changes reduce the value of their investments, such as faster-than-anticipated prepayments in an environment of declining long-term rates.

· Investment/Funding Risk – Owning non-investment-grade mortgage-backed securities are prone to greater losses of principal and interest than investments in better-quality securities. As mortgage REITs usually fund themselves with short-term repos (repurchase agreements), which are subject to daily margin calls, they can face sudden funding and liquidity problems. The investment risk is more if the investments are in junior CMBSs, and in commercial loans that are less liquid. Mortgage REITs that have invested in RMBS securities carry much less risks.

· Credit Risk – There is always a credit risk involved when the economy, and the real estate markets, slow down, as defaults may become an issue for mortgage REITs that make construction loans. Mortgage REITs investing in highly rated private label RMBS, carry very low credit risk.

Today, mortgage REITs are better prepared to meet with, and deal with, the adverse market environments. However, certain challenges remain, and if you are looking to invest in mortgage REITs, understand the risk factors involved before you invest.

© Copyright 2004 by Buyincomeproperties..com