As an income investor, some of the highest-yielding products you can buy are mortgage real estate investment trusts (mREITs). As a trader, some of the most dangerous products you can buy are mREITS.
Indeed, you must be extremely careful when purchasing mREITs because their price (not value) can fluctuate wildly on the stock market.
To understand mREITs (for smart investing), you must understand mortgage-backed securities (MBS). Depending on the economy, MBS and treasury bonds work together (and against one another).
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Understanding bond relationships. Bond investors derive the price of a bond based on risk versus one another. A good starting point for investing in bonds is “The Bond Book.”
The starting point of the bond pricing hierarchy is the Federal Funds Rate which the Federal Reserve sets during its eight annual meetings.
The US Treasury sets the interest rates on Treasury products (bills, notes, bonds) based on the Federal Funds Rates. For example, if the Funds Rate is 2%, the 2-Year Treasury Note may be 2.6%, the 10-Year note may be 3.0%, and the 30-Year Bond may be 3.5%.
It’s important to note that the interest rate on the Treasury bond is not the effective rate you will receive when you purchase them. This is because you purchase them at auction, and the market determines the price (that’s a separate article).
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Bonds and risk. Bond investors consider Treasury Bonds risk-free assets—meaning investing in a Treasury bond is similar to holding money in a bank.
Therefore, anything riskier than a Treasury Bond will require a higher interest rate to attract buyers. I wrote about this dynamic in “Treasury Bonds vs. Preferred Shares.”
Therefore, as bond traders bid up and down Treasury prices and yields, the cost of other bond products also fluctuates. The bond market is much larger than the stock market.
Mortgage-backed securities vs. Treasury Bonds. Bond investors consider conforming MBS products to be merely risk-free products.
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Freddie Mac and Fannie Mae purchase most conforming home loans (Rocket Mortgage). This means that the US government insures most homes mortgages that meet their standard.
Freddie Mac and Fannie Mae can package mortgages together to form Mortgage-backed Securities, which are basically home bonds.
MBS prices usually trade against the 10-Year Treasury Note plus a risk multiplier. For example, if the 10-year Treasury Note is 3%, mortgage rates may be 4%. Here is a chart from Black Knight Inc.
Because MBS prices and Treasury notes trade against one another daily, you always see mortgage rates jumping up and down.
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When you purchase a home, you usually get a rate lock to protect you from fluctuations for 30-60 days. Interest rates typically don’t jump too much over 30 days, but if the Federal Funds Rate increases drastically (like in 2022), mortgage rates will also jump.
What are mortgage REITs? Mortgage REITs are corporations that invest in MBS, many buying conforming mortgages from the US Government.
Mortgage REITs differ from equity REITs because equity REITs typically purchase physical property and receive rent payments.
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Mortgage REITs buy mortgages (paper) and receive loan payments. Understanding the difference between equity REITs and mortgage REITs is vital for your investing thesis. Please read “Debt vs. Equity” to understand this critical dynamic.
How do Mortgage REITs produce such high dividends? Mortgage REITs use leverage (borrowed money) to purchase their MBS.
They make their money from the difference between their loan and the mortgage interest rate. For example, if they can borrow money for 2% and purchase loans that offer 5% interest, their spread is 3%.
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Remember, this is a straightforward explanation. Mortgage REITs companies are complex and are not for the average investor.
Why are mREITs dangerous? mRIETs are hazardous because the price fluctuates like they are MBS bonds. If you do not understand the bond markets, you will see the market erase your capital gains.
Don’t worry, mREITs burned me in 2021-2022 because of my lack of knowledge. When the Federal Fund Rate was 0%, people flocked to MBS to get roughly 3% yields.
This buying increased the price of my favorite mREITs, AGNC and NLY, to sky-high proportions. I remember buying AGNC at $15 a share; however, AGNC was trading at $8 in August 2022.
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What is book value? Most investors base mREITs prices on their book value. The par for a bond or MBS is 100.
Therefore, when people seek MBS over Treasury bonds, the price goes up, let’s say to 110. However, when Treasury bonds trade at 4%, all the MBS at 3% most reprice. Let’s say the par value goes to 85.
mREITs prices on the stock market will follow these fluctuations of book value. However, mRIETs still receive loan payments, and nothing is truly changing in their business cash flow.
The theoretical value of their MBS went down based on the value against Treasury Bonds. As long as mREITs don’t sell all of the MBS at once, they are okay.
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Investing in mREITs. You must understand the dynamic between MBS and Treasury bonds to invest in mREITS successfully. I consider mREITs to be one big MBS where I can invest my money.
That means the best time to invest in mREITs is when mortgages are out of favor compared to Treasury bonds.
When Treasuries offer massive attractive yields, mortgages and MBS may be out of favor. You can look at the chart for AGNC and NLY and see if they are suffering. Their yields maybe 13-15%.
The trick is to stop buying as mortgages gain favor. That’s how mREITs burned me in 2021. Treasuries offered like 1.3% yields, while MBS offered 3-3.5%.
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This means that mortgages were in favor, and the book value of AGNC skyrocketed. The price of their bonds was probably 110 to 115 (much higher than the par of 100).
I kept dollar-cost averaging in AGNC when I should have kicked back and collected the dividends. I learned my lesson in blood, but I still love investing in mREITs.
Conclusion. You need more than this article for you to start investing in mREITs. I still have much more to discuss, so consider this an introduction to mREITs.
Today, Treasury bonds offer almost 4% yields, and all the 3%-yielding MBS that mREITs hold are selling below par.
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That means their book value and stock market price are low. I am buying hand over fist and getting massive yields.
However, as AGNC buys mortgages yielding 6-7% from Freddie Mac and Fannie Mae, things will get interesting.
It may take 3-5 years, but what if the Federal Funds Rate returns to zero? AGNC and NLY will hold 6-7% mortgages against 1-2% Treasury Bonds.
The book value will skyrocket as we have never seen. If you are a long-term investor and love dividends, you can do great things with mREITs. Please ensure you understand the relationship between MBS and Treasuries first. Good Luck!
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Disclosure: I am not a financial advisor or money manager, and any knowledge is given as guidance and not direct actionable investment advice. I am an Amazon Affiliate. Please research any investment vehicles that are being considered. 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. All Right Reserved Military Family Investing
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