Many investors assume that mortgage pool funds and mortgage REITs are similar types of investments. After all, both generate passive income from real estate; both pay sizable dividends to their shareholders and both are often categorized as alternative assets. Despite their similarities, however, there are some significant differences between mortgage pool funds and mortgage REITs that may impact the safety, reliability and overall attractiveness of each investment.
Let’s begin with a brief description of each:
A Mortgage Pool Fund is constructed from a portfolio of real estate loans owned collectively by the fund’s subscribers. The fund takes in money from investors and uses the capital to make loans to real estate developers and rehabbers. Loans made by mortgage pool funds are generally short-term (one to five years) and resemble bridge or sub-prime loans in paying above-average interest rates. However, mortgage pool lending is less risky than sub-prime debt since the loan is secured by a tangible asset (i.e. real estate).
Mortgage pool funds focus on a particular lending niche (professional real estate investors) and have refined their underwriting strategy to manage risk. In addition, these funds further reduce risk by maintaining a sizable spread between the amount of the loan and the value of the collateral property. This spread is referred to as the loan-to-value ratio. Most mortgage pool funds limit their loan-to-value ratio to below 70%.
A Mortgage REIT (also known as mREIT) is a special kind of REIT that invests only in mortgage debt. Unlike mortgage pool funds, these REITs don’t lend directly to borrowers; instead, they acquire existing mortgages on the secondary mortgage market. There are two types of mortgage REITs: agency REITs, which purchase mortgages backed by a federal guarantee (Fannie Mae, Freddie Mac and Ginnie Mae), and non-agency REITs, which acquire mortgages that are not backed by a federal agency. In general, non-agency mortgage REITs must pay higher dividends than agency REITs to compensate investors for greater default risk.
Due to their differing structures and portfolio strategies, mortgage pool funds and mortgage REITs have distinctly different risk profiles. Here are four major differences between the two types of investments:
Leverage. A key difference between mortgage pool funds and mortgage REITs is the amount of leverage on the portfolio. Mortgage REITs employ a substantial amount of leverage, often as much as 5:1. These REITs aim to borrow cheaply and boost returns by reinvesting the proceeds in higher-yielding mortgage-backed securities. With current rates on 30-year mortgage loans near 3.5%, many mortgage REITs must increase portfolio leverage to maintain competitive yields. Historically, as much as 3-4% of the annual return generated by a mortgage REIT has come from redeploying short-term borrowings into long-term mortgages. This is an effective strategy for enhancing dividend yields when short-term interest rates are low, but can backfire when short-term rates begin to rise. When short-term rates approach the same levels as long-term rates, funding gaps narrow, portfolio income declines and mortgage REIT are often forced to cut or even eliminate dividends. Mortgage REITs can also encounter challenges when long-term rates rise and the value of the existing mortgages in the portfolio declines. If leverage is high, the reduction in portfolio value may wipe out some of the REIT’s equity. Market value is impacted by book value, so the mortgage REIT’s share price would likely decline.
Interest rate risk. Due to their reliance on short-term borrowing and long-term mortgage investments (i.e. 15-30 years), mortgage REITs carry a substantial amount of interest rate risk. When interest rates rise, mortgage REITs are at risk of paying more to borrow funds than can be earned from their existing mortgage investments. Although there is also a certain amount of interest rate risk associated with mortgage pool funds, this risk is much smaller due to the shorter duration of their loans. The typical duration of the loans in a mortgage pool fund portfolio is one to five years versus 15-30 years for a mortgage REIT portfolio.
Market Risk. One of the best reasons to own real estate is its low correlation with stocks and bonds. In fact, many financial advisors recommend adding real estate to a portfolio to improve diversification and reduce risk. Mortgage pool funds have been shown to move independently of stocks. At one time REITs were also poorly correlated to stocks, but that relationship has changed in recent years. During the 2008-09 recession, the REIT sector (as measured by the Vanguard REIT Index Exchange Fund) lost 38 percent of its value, which was roughly the same loss as the overall stock market. According to a 2012 Wall Street Journal article, during the decade prior to 2012, the correlation between REITs and the stock market more than doubled.
Reliable income. Mortgage REITs may sometimes offer very attractive dividend yields, but their payout is rarely consistent and these REITs are often forced to cut dividends when the gap between long-term and short term interest rates narrows. During the recession, many mortgage REITs were forced to suspend dividends altogether. Even during the economic recovery that followed, a number of mortgage REITs have cut dividends. According to Barron’s, nine of 23 large mortgage REITs cut dividends in 2015. Dividend cuts are not always the result of rising interest rates. Other reasons may include non-performing loans, poor management and a lack of reinvestment opportunities in the secondary mortgage market when existing mortgages are paid off early.
The current low interest rate environment is favorable to both mortgage pool funds and mortgage REITs, but the long-term consensus is for rising rates, which will no doubt create dividend challenges for debt-dependent REITs. Because of their modest leverage and shorter-term loans, mortgage pool funds are better positioned to adapt to changing interest rates and protect dividends for their investors.