Individual real estate investment trusts (REITs) fall into one of two distinct categories. Equity REITs own commercial properties, including apartments, hotels, offices, industrial properties, and even prisons. Finance REITs operate on the lending side of real estate, either by making residential or commercial mortgages or owning a portfolio of mortgage backed securities. Finance REITs can also be separated into to camps, based on their business strategies. Those differences can make a difference for investors in their high yield stock portfolios.
In both size of companies and number of stocks, the finance REIT sector is dominated by companies that invest in residential mortgage products. The most common business model in this group is to own portfolios of residential mortgage backed securities (MBS). These MBS own mortgages guaranteed by the federal agencies of Fannie Mae, Freddie Mac, and Ginnie Mae. These high yield stocks sound safe because of the implied federal government backing of the mortgages in their portfolios.
The problem comes with the steps these companies must take to turn 3% agency MBS yields into 10% plus REIT yields. The yield step-up requires leveraging a REITs equity 5 to 8 times. The whole business model is to own longer duration MBS acquired with short term financing. They can hedge some of the interest rate risk, but an inverted yield curve would turn net interest income into big losses for this group of REITs. I am not going to name names today. I have found that some readers don’t closely read my arguments and can mistake stocks to buy from stocks to sell.