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 cash flows consisting of interest payments and repayment of principal. Also, both types of securities can create capital gains or losses if the prices of the underlying debt instruments change. Although they share several characteristics, MBS differ from mREITs in a few significant ways.

Introduction to Mortgage-Backed Securities

Origins

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

In 1986, the Tax Reform Act created a type of special purpose vehicle called a real estate mortgage investment conduit, or REMIC. The purpose of a REMIC is to issue mortgage-backed securities that are exempt from corporate tax. Instead, the income and expenses of a REMIC are passed through to the bondholders, who pay income tax on the net income. The 2007 mortgage meltdown was partially due to the proliferation of low-quality MBS backed by subprime mortgages. The market for high-quality MBS recovered by 2012 and is once again vibrant.

Types of Mortgage Bonds

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

Securitization Trusts

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

Pass-Through Securities (PTS)

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

Collateralized Mortgage Obligations (CMOs)

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

Strips

Strips are securities that separate the cash flows arising from payments of interest versus principal. Interest-only (IO) strips receive only the interest portion of a pool’s income. Principal-only (PO) strips work similarly. A change in interest rates can greatly affect investor returns on strips. For instance, if rates fall, homeowners typically refinance their mortgages, thereby providing large 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 in order to earn interest income on these investments. MREITs can hold residential debt, commercial debt or a mix of both. You invest in mREITs the same way you invest in equity REITs — through purchase of the company stock. Both types of REITs must distribute at least 90% of their income to shareholders. MREITs are far outnumbered by equity REITs, but they usually pay a higher dividend yield. REITs pay no income tax – they are pass-through securities.

Comparison Between Investing in mREITs and MBS

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

Minimum Investment

Agency MBS are sold in varying denominations, usually starting 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 an individual investor can purchase a single MBS or CMO, albeit with commissions and fees.

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

Timing Risk

If you hold a bond to maturity, you avoid the timing risk that 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 before maturity risks might result in a lower-than-expected sale price if interest rates rose since your purchase. That’s because bond prices move in the opposite direction 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 either direction can hurt MBS prices. To the extent that interest rate movements can sometimes occur without warning, MBS investors are exposed to timing risk.

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

Diversification

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

Involvement

Both mREITs and MBS are passive investments that require no interaction with the underlying properties. Thus, both are suitable for inclusion in tax-advantaged investment vehicles, such as employer retirement plans and IRAs.

Leverage

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

Risk

Debt investments carry several types of risk. Default risk is the likeliness that a borrower will fail to repay a loan. Defaults reduce the value of MBS and mREITs. Interest rate changes also introduce the risk of price volatility. As explained earlier (see Timing Risk), if interest rates rise, the underlying debt in mREITs and MBS is worth less, and their prices should fall. Prepayment risk deals with a shortfall in interest collected from a mortgage. Rising prepayments hurt the prices of mREITs and MBS. This is especially true of secondary CMO tranches that don’t receive their interest or principal payments until senior tranches do.

For example, Investor A might buy $1 million face value of a 6%, 5-year secondary CMO tranche for $1.1 million (purchasing at a premium) and expect to receive interest income of about $60,000 in Year 1. Interest payments in Years 2 through 5 will drop due to mortgage amortization — more of the pooled mortgage-holders’ monthly payments will be allocated to principal repayment as time passes. The predicted speed of principal repayments (and prepayments) is modeled on the current interest rate landscape, and this implies how much interest the pool will collect each year. This, in turn, provides an estimate for yield-to-maturity on the various CMOs backed by the pool.

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

MREITs, which own mortgages and MBS, are subject to the same interest rate, default prepayment risks. However, because mREITs are professionally managed, they can employ various sophisticated techniques for hedging these risks. MBS issuers provide no such professional hedging, leaving it to investors instead.

Efficiency

Several fees apply to MBS and mREITs. Fees cover the costs of obtaining, collecting, pooling and dividing mortgages. Higher fees are required when CMOs have complex tranche arrangements, as principal and interest must be precisely allocated to each tranche. MREITs allocate some income from their 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, might have thin liquidity that can distort prices. Non-traded REITs and private REITs are highly illiquid, and the latter are restricted to accredited investors.

Summary

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