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 can invest in and own mortgages as an alternative to owning commercial properties. REITs are typically some of the highest-yielding stocks available on the market.
What Are REITs?
Typically, REITs are companies that finance, operate, or own revenue-generating real estate investments of various kinds that span across multiple property sectors. These companies are usually publicly traded. Real estate investment trusts can own residential, commercial real estate properties, or mortgage-backed securities (MBS).
REITs are formed under a special tax rule that allows them to pay no income tax if most of their earnings pass through to investors as dividends. The general rule of thumb is that REITs must pay out at least 90 percent of their taxable income to shareholders in the form of 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.
Basics of Mortgage REITs
Mortgage REITs – as the name implies – own pools of mortgage-backed securities (MBS). An MBS is a bond of sorts that consists of a set or pool of home loans that REITs purchase from the financial institutions that issued them. These pools are categorized based on similar characteristics, such as property type, geographical location of investment, etc. Each pool is assigned to a trust, which then issues the MBS.
These companies use the leverage of borrowed money to boost the return from the securities they own. For example, suppose a real estate investment trust considers purchasing $1 million of MBS that yields 4 percent and produces $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 can pay the high yields for which they are known, even when mortgage rates are low.
Agency vs. Non-Agency MBS
Mortgage-backed securities (MBS) exist in the form of agency mortgage-backed securities, and non-agency mortgage-backed securities.
1. Agency Mortgage-Backed Securities
Agency mortgage-backed securities are mortgage bonds issued by the government-backed or government-supported agencies via the open bond market. These agencies include Ginnie Mae, Freddie Mac, and Fannie Mae.
The home mortgages in the pools that back the securities are guaranteed the principal repayment by the agencies, thus giving the securities a high level of credit safety. Ginnie Mae MBS, in particular, are deemed to be without credit risk at all. However, the agency MBS may underperform, especially when homeowners prepay their mortgages or refinance.
2. Non-Agency Mortgage-Backed Securities
Non-agency mortgage securities are backed by real estate loans that are not guaranteed by the listed agencies. Instead, it is usually private companies without government backing doing the sponsoring.
The loans in these pools may be jumbo home mortgages not eligible for agency underwriting or mortgages on commercial properties. An example is the non-agency RMBS, which refers to residential mortgage-backed securities that are pegged on the interest paid out for home loans, such as subprime mortgages and home equity loans.
Without the agency backing, non-agency mortgage securities pay higher interest rates but are subject to default risk.
Which MBS Should You Invest In?
An investor considering mortgage REIT investments should understand the type of mortgage securities held by a specific REIT. On one hand, agency mortgage REITs hold safe, liquid securities, but are subject to interest rate risk. Thus, rising short-term rates on borrowed money can destroy a mortgage REIT's ability to pay dividends.
On the other hand, you must evaluate non-agency REITs based 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 indicate the risk involved with these investments.
- Reit: What's a REIT (Real Estate Investment Trust)?
- Corporate Finance Institute: Real Estate Investment Trust (REIT)
- AssetsAmerica: Agency Loans & Non-Agency MBS – Ultimate Guide
- WesternAsset: The Advantages of Agency Mortgage-Backed Securities
- Guggenheim: Non-Agency Residential Mortgage-Backed Securities: Building Blocks for Recovery
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.