Bought a mortgage REIT thinking it was the same thing as an equity REIT. It was not.

This one is fully on me and it cost about 11k.

Early last year I was moving money out of a construction business account into something liquid and I wanted real estate exposure with income. I'd read enough to know REITs pay out most of their taxable income and that yields run higher than the market. So I screened for yield, found a name paying north of 11 percent, checked that it said REIT, checked that the word mortgage was in the name and thought, fine, that's real estate lending, I understand lending, I've been on the borrower side of construction loans for fifteen years.

What I did not understand is that a mortgage REIT is a leveraged spread business. It doesn't own buildings. It owns paper, mostly funded with short term borrowing, and it earns the difference between what the paper yields and what the funding costs. When that spread compresses or the funding market gets tight, book value takes the hit, and the dividend that looked like income was partly a return of my own capital.

Put in 60k. Collected roughly 6,400 in distributions over about fourteen months. Sold at a loss of just over 17k on the position. Net down about 11k, and a chunk of what I collected turned out to be return of capital which changed my basis in a way I did not anticipate and had to pay someone to sort out at tax time.

Where it actually went wrong was the screen. I screened on yield and sector label, and a yield above 10 percent in a sector where the index average runs 4 to 6 was telling me something I chose not to hear. High yield in this space is usually the market pricing doubt about the payout, or it's a fundamentally different business model, and in my case it was both.

What I'd do differently: read what the company actually owns before the dividend number. Equity REITs own income producing property and their fortunes track rents, occupancy, and supply. Mortgage REITs own loans and securities and their fortunes track rate spreads and funding availability. Both are called REITs. They are not substitutes.

6 replies

1hannah_west29 Get yours

I want to disagree slightly on the cause. You've framed this as not knowing the difference between equity and mortgage REITs, which is true but I think it's the second error.

The first error is that you sized a 60k position on a screen. You didn't read a 10-K, you didn't look at book value per share, you didn't look at the funding mix or the hedge book. You'd never buy a piece of ground for 60k on a listing photo. Same discipline should apply, and the fact that a brokerage account makes the purchase take four seconds is exactly why it doesn't.

The mortgage REIT thing you could have learned from one paragraph of the annual report. The sizing habit is what will get you again in a different sector.

On the return of capital piece, that's worth flagging for others because it surprises people. Distributions get characterized across ordinary income, capital gain, and return of capital, the split shows up after year end, and return of capital reduces your basis so it shows up later as a bigger gain or smaller loss. How that lands for any individual is a question for a tax professional.

1raj_mehta14CapitalPRO6

I've had my head in notes material for months, and what a mortgage REIT actually is finally clicked here, so thank you for paying 11k for it.

The part I'm still fuzzy on. When you say funded with short term borrowing, is that repo? I keep hitting that word and skating past it.

1ryanmck27SC2C

@vellum, repo is essentially a short term secured loan where the securities are the collateral, and yes, a lot of that funding is repo. The risk is that it has to be rolled constantly. If the lender wants more collateral because the securities fell in value, you're selling into the same weak market that caused the problem.

Girder, one thing I'd add to your list. There are also hybrid names and there are REITs that hold both property and loans, so the label doesn't always split cleanly. The only reliable way to know is the asset schedule.

2mitchell_ray4 Get yoursPRO6

Coming from the trades I appreciate that you wrote this without beating yourself up about it. Genuine question though, would you have caught it if the dividend had been 7 percent instead of 11? That's high but not absurd, and I'm trying to work out where my own alarm bell should sit.

1joe_delgado5AP4CPRO6

@solder, at 7 you probably wouldn't catch it on yield alone, which is why the yield screen is a bad primary filter at any level. What you'd catch it on is payout coverage. For an equity REIT you compare the dividend to funds from operations, and if the dividend is most or all of FFO there's nothing left for capex or debt paydown and the payout is fragile. For a mortgage REIT the equivalent question is whether distributable earnings cover the dividend, and often they don't, which is where the return of capital girder ran into comes from.

I've made a version of this mistake with a net lease name where the tenant roster was two thirds one struggling retailer. Yield was 8, coverage looked fine on paper, and then the tenant restructured. Different mechanism, same root, I bought a number instead of a business.

Bought a mortgage REIT thinking it was the same thing as an equity REIT. It was not.

6 replies