REITs vs. Mortgage-Backed Securities (2024)

This is the fourth article in our series about ways to invest in real estate.

In this article, we’ll compare mortgage-backed securities(MBS), also known as mortgage bonds, against REITs, specifically mortgage REITs(mREITs). MREITs differ from equity REITs in that they own real estate debt(mortgages and MBS) rather than real estate. Both mREITs and MBS provide cashflows consisting of interest payments and repayment of principal. Also, bothtypes of securities can create capital gains or losses if the prices of theunderlying debt instruments change. Although they share severalcharacteristics, MBS differ from mREITs in a few significant ways.

Introduction to Mortgage-Backed Securities

Origins

The U.S. government created the Federal National MortgageAssociation, or Fannie Mae, in 1938 to form a liquid secondary market for bondsbacked by fixed-rate mortgages insured by the Federal Housing Administration(FHA). Fannie bought up FHA mortgages and redistributed them as bonds publiclyavailable for purchase from the agency and tradable on the bond exchanges. In1970, part of Fannie Mae was hived off to another agency, the GovernmentNational Mortgage Association (Ginnie Mae), and the sources of mortgage debtwere expanded to include the Veterans Administration and the Farmers HomeAdministration. In addition, Congress for the first time authorized Fannie topurchase private mortgages (not insured by a federal agency). In contrast, GinnieMae does not issue bonds backed by private mortgages. Congress in 1970 alsocreated another government-sponsored enterprise, the Federal Home Loan MortgageCorporation (Freddie Mac), to expand the market for mortgage-backed debtfurther.

In 1986, the Tax Reform Act created a type of specialpurpose vehicle called a real estate mortgage investment conduit, or REMIC. Thepurpose of a REMIC is to issue mortgage-backed securities that are exempt fromcorporate tax. Instead, the income and expenses of a REMIC are passed throughto the bondholders, who pay income tax on the net income. The 2007 mortgagemeltdown was partially due to the proliferation of low-quality MBS backed bysubprime mortgages. The market for high-quality MBS recovered by 2012 and isonce again vibrant.

Types of Mortgage Bonds

It is standard practice for banks to sell most of themortgages they originate to one of the government-sponsored entities for securitization.Governmental or private agencies buy up mortgages from banks and other lendersand create huge mortgage pools. They then issue mortgage-backed securities toinvestors, backed by the mortgages in these pools. MBS provide investors withcash flows arising from mortgage payments. MBS range from simple “pass-through”vehicles to complex financial instruments backed by residential and commercialmortgages.

Securitization Trusts

Governmentalagencies create most mortgages pools. These and other securitization trusts annually create pools worthbillions of dollars. The sale of MBS backed by these pools raises capital thatallows the agencies to partially subsidize new mortgages. Investors can selectthe types of MBS that most closely reflect their risk/return objectives.

Pass-Through Securities (PTS)

The simplest typeof MBS is the pass-through security. A PTS issuer operates by passing monthlycash flows from mortgage pools to investors. The mortgage pools pay no taxes onthe monthly income. Instead, the tax obligations pass through to investors,along with the cash payments. The securitization trust cannot alter thecomposition of PTS mortgage pools and must keep commercial and residentialmortgages in separate pools. PTS do not provide investors the opportunity toreinvest the monthly cash payment back into the pools.

Collateralized Mortgage Obligations (CMOs)

CMOs are acategory of MBS representing debt that is collateralized by an asset, in thiscase, mortgage pools. CMOs are divided into multiple classes that eachrepresents a slice, or “tranche”, of a pool’s payments. For instance, onetranche may be designated to receive all principal payments first, and onlywhen it was fully repaid would a second tranche start receiving principalpayments. Whereas PTS receive a pro-rated monthly distribution of interest andprincipal payments, CMOs operate through a priority schedule for principalpayments among the tranches. Other schemes for dividing mortgage pools intoCMOs are to group mortgages by their interest rates or their riskiness.Different tranches may be paid in parallel or serially, depending on how thetrust has structured the pool.

Strips

Strips aresecurities that separate the cash flows arising from payments of interestversus principal. Interest-only (IO) strips receive only the interest portionof a pool’s income. Principal-only (PO) strips work similarly. A change ininterest rates can greatly affect investor returns on strips. For instance, ifrates fall, homeowners typically refinance their mortgages, thereby providinglarge cash flows to owners of PO strips but truncating the IO strip cash flows.Owners of the IO strips would thus receive a lower return than anticipated.

Mortgage REITs

MREITs are companies that originate/buy mortgages and MBS inorder to earn interest income on these investments. MREITs can hold residentialdebt, commercial debt or a mix of both. You invest in mREITs the same way youinvest in equity REITs — through purchase of the company stock. Both types of REITsmust distribute at least 90% of their income to shareholders. MREITs are faroutnumbered by equity REITs, but they usually pay a higher dividend yield. REITspay no income tax – they are pass-through securities.

Comparison Between Investing in mREITs and MBS

Publicly traded mREITs and MBS are available from theirissuers and/or on secondary exchanges. Although mREITs provide interest income,technically they trade as shares and the interest is paid out as dividends. MBStrade as bonds.

Minimum Investment

Agency MBS are sold in varying denominations, usuallystarting at $10,000. Private-label CMOs are often sold in $1,000 units. Typically,institutional investors snap up MBS in multi-million-dollar lots. But anindividual investor can purchase a single MBS or CMO, albeit with commissionsand fees.

You can buy a single share of an mREIT, typically for wellunder $100.

Timing Risk

If you hold a bond to maturity, you avoid the timing riskthat would apply if you sold before maturity. Bonds repay their face value,which is a known amount when you purchase the bond. Selling an MBS beforematurity risks might result in a lower-than-expected sale price if interestrates rose since your purchase. That’s because bond prices move in the oppositedirection from interest rates. Unique to MBS, interest rate decreases can cause property owners to refinance,leading to a shortfall in interest payments for existing MBS. This, in turn,reduces the value of the MBS. Therefore, interest rate movements in eitherdirection can hurt MBS prices. To the extent that interest rate movements cansometimes occur without warning, MBS investors are exposed to timing risk.

You also take on timing risk when you buy mREIT shares in alump sum, as mREIT share prices can be volatile. As we’ve explained in earlierarticles, you can employ dollar-cost-averaging (DCA) to reduce the timing riskof purchases. With DCA, you make equal-sized purchases on a regular basis, sothat you buy more shares when they are cheap, and fewer shares when they aredear. Naturally, you can also employ DCA when purchasing MBS.

Diversification

Both investment types offer diversification, since they arebacked by pools of many mortgages. Owning either increases your allocation indebt instruments that differ from corporate and Treasury bonds. Thediversification effects of mREITs are limited by the real estate sectors inwhich the mREIT operates. For example, mREIT debt might be limited tomultifamily properties, office buildings or retail stores. Pass-through MBSpools typically contain residential or commercial property debt, although somemight offer a mix. CMOs and strips allow you to customize your holdings byselecting tranches with the desired risk/reward tradeoffs. To achieve maximumdiversification, you might have to invest in multiple mREITs and MBS offerings.

Involvement

Both mREITs and MBS are passive investments that require nointeraction with the underlying properties. Thus, both are suitable forinclusion in tax-advantaged investment vehicles, such as employer retirementplans and IRAs.

Leverage

If you qualify for broker margin, you can buy mREIT sharesand MBS bonds in the secondary market with up to 50% leverage. In addition,many of the esoteric CMO tranche types are highly leveraged instruments. Forexample, an inverse floating-rate CMO usually incorporates high levels ofcoupon leverage — the amount by which you multiply a reference rate todetermine the floating interest rate. The prospectus for a publicly traded CMOtranche will explain how it utilizes leverage.

Risk

Debt investments carry several types of risk. Default risk is the likeliness that aborrower will fail to repay a loan. Defaults reduce the value of MBS andmREITs. Interest rate changes also introduce the risk of price volatility. Asexplained earlier (see Timing Risk), ifinterest rates rise, the underlying debt in mREITs and MBS is worth less, andtheir prices should fall. Prepayment riskdeals with a shortfall in interest collected from a mortgage. Risingprepayments hurt the prices of mREITs and MBS. This is especially true ofsecondary CMO tranches that don’t receive their interest or principal paymentsuntil senior tranches do.

For example, Investor A might buy $1 million face value of a6%, 5-year secondary CMO tranche for $1.1 million (purchasing at a premium) andexpect to receive interest income of about $60,000 in Year 1. Interest paymentsin Years 2 through 5 will drop due to mortgageamortization — more of the pooled mortgage-holders’ monthly payments willbe allocated to principal repayment as time passes. The predicted speed of principal repayments (andprepayments) is modeled on the current interest rate landscape, and thisimplies how much interest the pool will collect each year. This, in turn,provides an estimate for yield-to-maturity onthe various CMOs backed by the pool.

However, the speed of thepool’s principal prepayments will increase if interest rates fall, asmortgage-holders pay off their existing mortgages by refinancing at the lower interestrates. If prepayments rise for the mortgages in the pool backing this CMOissuance, less interest will be collected from the pool’s mortgage holders. Thesenior CMO tranche from this pool will collect the pool’s interest andprincipal payments ahead of the secondary tranches. Meanwhile, the refinancedmortgages will enter new pools with lower interest rates. The drop in thenumber of remaining active mortgages in the original pool means that the pool’sinterest income will fall, and Investor A’s CMOs will produce interest incomebelow the expected annual amounts. Furthermore, the interest payments to theoriginal pool will dry up before the maturity date as mortgages terminate beforematurity. The result is that Investor A’s yield-to-maturity will not meetexpectations due to prepayment risk.

MREITs, which own mortgages and MBS, are subject to the sameinterest rate, default prepayment risks. However, because mREITs areprofessionally managed, they can employ various sophisticated techniques forhedging these risks. MBS issuers provide no such professional hedging, leavingit to investors instead.

Efficiency

Several fees apply to MBS and mREITs. Fees cover the costsof obtaining, collecting, pooling and dividing mortgages. Higher fees arerequired when CMOs have complex tranche arrangements, as principal and interestmust be precisely allocated to each tranche. MREITs allocate some income fromtheir bond portfolios to provide profits to the mREIT company.

Liquidity

Publicly traded mREITs and MBS are usually highly liquid.However, some CMO tranches, such as strips and Z-tranches, mighthave thin liquidity that can distort prices. Non-traded REITs and private REITsare highly illiquid, and the latter are restricted to accreditedinvestors.

Summary

Compared to mREITs, MBS are more complex and require asophisticated understanding of several types of risks. MREITs provide investorswith professional management that can help mitigate risks. For those who preferprofessional management, REITs and MBS fundsare alternatives to the direct purchase of MBS. We’ll explore real estatefunds in our next installment of this series on ways to invest in real estate.