Agency and non-agency real estate investment trusts are subsectors of the mortgage sector of the real estate investment trust, or REIT, universe. Real estate investment trusts are allowed to invest in and own mortgages as an alternative to owning commercial properties. Mortgage REITs are typically some of the highest-yielding stocks available on the market.
Real estate investment trusts are businesses that own commercial real estate properties or mortgages. REITs are formed under a special tax rule that allows them to pay no income tax if the majority of earnings is passed through to investors as dividends. Most REITs focus on a specific sector such as apartment buildings, shopping centers, office buildings, commercial buildings or mortgages. The shares of publicly traded REIT companies are bought and sold through a stock brokerage account in the same manner as any publicly traded company.
Mortgage REITs -- as the name implies -- own pools of mortgage-backed securities -- MBS. These companies use the leverage of borrowed money to boost the return from the securities they own. As an example, consider the purchase of $1 million of MBS yielding 4 percent, producing $40,000 per year in interest. The REIT finances the purchase by borrowing $800,000 at 2 percent and using $200,000 of company capital. The result is $24,000 of net interest earnings on $200,000 of invested capital for a 12 percent annual return. This process is how the mortgage REITs are able to pay the high yields for which they are known, even when mortgage rates are low.
Agency vs. Non-Agency Mortgages
Agency mortgage-backed securities are mortgage bonds issued by the government-backed or government-supported agencies of Ginnie Mae, Freddie Mac and Fannie Mae. The home mortgages in the pools that back the securities are guaranteed the repayment of principal by the agencies, giving the securities a high level of credit safety. Non-agency mortgage securities are backed by real estate loans not guaranteed by one of the listed agencies. The loans in these pools may be jumbo home mortgages not eligible for agency underwriting or mortgages on commercial properties. Without the agency backing, non-agency mortgage securities pay higher rates of interest but are subject to default risk.
Risks and Considerations
An investor considering mortgage REIT investments should understand the type of mortgage securities held by a specific REIT. Agency mortgage REITs hold safe, liquid securities, but are subject to interest rate risk. Rising short-term rates on borrowed money can destroy a mortgage REIT's ability to pay dividends. Non-agency REITs must be evaluated on the types of mortgages they hold and the possibility of default if real estate values decline. The high yields paid by both types of mortgage REITs are an indication of the risk involved with these investments.
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