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Mortgage REITs 101: How These High-Yield Investments Work - The Motley Fool

Mortgage REITs are high-income investments, but there's a lot to know before buying.

Real estate investment trusts that invest in mortgages, also known as mortgage REITs, often have tempting high yields. But like any investment, they aren't right for everyone. In this Fool Live video clip, recorded on Dec. 10, Fool.com contributors Matt Frankel, CFP®, and Marc Rapport, discuss how mortgage REITs work and how they can generate such high dividend yields.

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Matt Frankel: A mortgage REIT, or mREIT for short, is a real estate investment trust. It invests mostly in mortgages, similar financial instruments. Some own mortgage servicing rights, the right to be the company you send your mortgage payment to essentially, but as opposed to buying actual properties. Most real estate investment trusts fall in the category of equity REITs, which are companies that own physical properties.

Most mortgage REITs specialize in one or two types of loans. They don't just buy any old mortgages. Most have some focus. Annaly Capital Management (NYSE:NLY) is one we're going to talk about in a little while, which I believe Marc is a shareholder of. It primarily invests in agency-backed residential mortgages, something you might take out to buy your house, could be a loan that Annaly would want to invest in.

Investors are often attracted to mortgage REITs for their high yields, and this is why Marc brought up the topic when we were talking the other day. Annaly yields about 10.5% as we're talking. When you compare this to, as Marc said, a CD paying 1% or even an SP Index fund that pays 2% dividend, this is a pretty attractive income stream. It's not hard to see why people might be attracted to it. Marc, I believe you own shares of Annaly and maybe one other mortgage REIT.

Marc Rapport: I do. The other one is Broadmark (NYSE:BRMK), which is a very different kind of company in that they own construction back. They are direct lenders. Annaly is not that much of a direct lender if I understand it, but Broadmark is a direct lender to construction projects.

Matt Frankel: We're going to talk about both of them specifically a little bit later on. But because there's no such thing as a free lunch in the stock market. If it was really easy to achieve a 10% yield, no one would ever put their money into a CD. There are some risk factors and things like that investors should be aware of, and we're going to try to break down a little bit of it right now.

But first, it's important to understand the basics of how mortgage REITs work. Think of the average mortgage rate right now. Mine is at, I think, 3.125%. The average 30-year mortgage rate in the U.S. is about 3% right now. Simply investing in a mortgage that pays you 3% a year isn't going to get investors too excited. They'll just buy Treasury bonds or things like that.

What mortgage REITs will do, they'll use large amounts of leverage or borrowed money to increase their returns. They'll borrow money at short-term rates. Let's say that they can borrow money at 1% and use it to buy mortgages that pay 3% and do that several times over, and that's where Annaly's 10.5% yield comes from. They are financing it with borrowed money.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

Marc Rapport owns Annaly Capital Management and Broadmark Realty Capital Inc. Matthew Frankel, CFP® has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.