Real estate investment trust (REIT) companies must focus their business operations on one or more sectors of the real estate industry. So if a government-issued bond is related to real estate, the bond would be eligible to be a REIT holding. In fact, some REIT companies specialize in the ownership of this type of government backed security.
Mortgage Backed Securities
A mortgage backed security (MBS) is a bond backed by a pool of home mortgages. The interest and principal payments for an MBS are derived from the cash flows as homeowners make their house payments on the mortgages held in the pool. Agency MBSs are mortgage securities backed or guaranteed by a U.S. government agency or government sponsored entity (GSE). Agency mortgage securities — backed by Ginnie Mae, Fannie Mae and Freddie Mac — make up a large portion of the MBS market. Agency mortgage securities are a type of U.S. government debt security.
A dedicated sector of REIT companies specialize in the ownership of mortgage backed securities. Mortgage securities are broadly split into the two categories: government backed agency MBSs and non-agency MBSs. Strategies used by the different mortgage REIT companies include specializing in one or the other type of MBS or balancing between the two. Any REIT classified as a mortgage REIT will hold at least a portion of the investment portfolio in agency MBSs.
High Yield Investments
The mortgage REITs which primarily own agency backed MBSs are among the highest yielding stock investments. Dividend yields from these REIT shares can be well above 10 percent. The mortgage REIT strategy is to leverage (using borrowed money) the guaranteed interest rates paid by a portfolio of government-agency mortgage securities, producing a high return on the equity invested in the mortgage securities. The level of leverage can reach seven to eight times the amount of investor money actually used to buy mortgage securities.
REIT Classification Rules
To remain classified as a REIT for tax purposes, a company must stay in compliance with two main criteria. First, the company must derive at least 75 percent of its income from real estate sources. Owning government guaranteed mortgage backed securities meets this requirement. Second, a REIT must pay out at least 90 percent of net income to investors as dividends. As a result, many REIT stocks pay above average dividend yields, and the mortgage REIT stocks usually pay the highest yields of all the REIT types.