Mortgage Real Estate Investment Trust (mREIT)
What it is:
How it works (Example):
There are two types of mREITs: non-agency and agency. Agency loans are issued and guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. These agency securities are considered as creditworthy as U.S. Treasurys because they are backed by an actual or implicit guarantee of the U.S. government.
Non-agency debt is issued by investment banks. It generally offers higher yields than agency paper, but is less liquid and typically less credit-worthy. If the issuer defaults, the holder suffers losses.
Mortgage REITs profit from the difference, or spread, between interest rates earned on their mortgage loans and their short-term borrowing rates. For example, an mREIT that earns net interest income of 3% on its mortgage assets but only pays 1.25% to borrow money to buy those assets will earn 1.75% as a return on invested capital (ROIC).
Why it Matters:
Both agency and non-agency mREITs can be worthwhile investments. But mREITs that focus on agency mortgages eliminate one of the key risks associated with mortgage securities -- credit risk. But in exchange for lower exposure to credit risk, mREITs that hold agency bonds must accept a lower yield.
To boost returns, mREITs often use a significant amount of leverage. The additional risk involved with using leverage (default risk), combined with the interest rate risk and prepayment risk all fixed-income securities have, means that investors must be especially careful to match their own risk tolerance with that undertaken by each specific mREIT.