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What Is a Mortgage REIT?

Mortgage-backed securities got a black eye in the financial crisis, but real estate investment trusts that own them are currently generous to income income-oriented investors, with dividend yields averaging nearly 10 percent, according to the National Association of Real Estate Investment Trusts.

That's more than triple what you'd earn with a 10-year Treasury bond.

But with interest rates expected to rise, are they safe enough for a retiree who must preserve principal? Experts have mixed views.

Brad Case, an analyst at REIT.com, the national association's website, says in a late-February analysis that the large premium for mortgage REIT yields over Treasury and corporate bonds means the prospects for mortgage REITs over the next few years are good.

[See: The 10 Best REIT ETFs on the Market.]

"Is a current dividend yield in excess of 10 percent a signal that perhaps investors should look more closely at the investment opportunity in exchange-traded mortgage REITs?" Case says. "The historical data suggests that the answer should be yes."

Like ordinary bonds, mortgage securities can lose value when rising rates make older issues with lower yields less appealing. On the other hand, funds that own mortgage securities can gradually pay higher yields as newer securities are added to the portfolio.

"Rising interest rates ... mean rising mortgage rates for REITs, and ultimately more cash flow to investors," says Allen Shayanfekr, CEO of Sharestates, a real estate crowdfunding site. "Mortgage REITs are collateralized assets. They tend to offer higher returns than bonds and treasuries."

But some experts are cautious.

"Historically speaking, mortgage REIT returns tend to slow during rising-rate environments," says John LaForge, head of real asset strategy for Wells Fargo Investment Institute in Sarasota, Florida, referring to the way falling security prices can offset interest earnings.

"The real problem area for mortgage REITs comes in if rates move unexpectedly and quickly higher," he says. "Under this scenario, investors often treat mortgage REITs like a long-term bond, and performance often turns negative."

The most familiar type of real estate investment trust, the equity REIT, owns actual real estate -- apartment buildings, shopping malls, office centers and so on. But a small subset, mortgage REITS, invest in mortgage-backed securities, bundles of mortgages that pass homeowner's payments on to investors.

NAREIT identifies 34 mortgage REITs versus 167 equity REITS. Mortgage REITs are like bond funds and, like all REITS, appeal to investors seeking steady income, though equity REITS tend to offer larger capital gains if things work out.

REITS are traded like stocks or bought through mutual funds or exchange-traded funds.

"Mortgage REITs tend to have stronger yields (than equity REITs) and are less impacted by the ups and downs of the real estate market," says Adham Sbeih, CEO of Socotra Capital, a Sacramento, California, real estate investment firm.

Despite rising interest rates, many conditions are good for mortgage REITs. Mortgage defaults have fallen steadily since the financial crisis, housing prices have risen, the economy has strengthened and unemployment has fallen dramatically. All these factors reduce the risk homeowners will stop making payments, which would undermine mortgage REIT dividend payments and cause security prices to tumble.

[See: 9 ETFs to Buy When the Market Tanks.]

Rising rates also reduce prepayment risk, which occurs when falling rates drive homeowners to refinance, cutting the flow of higher-rate payments.

While all investments that depend on borrower payments have risk, Shayanfekr points out that mortgage debts are repaid ahead of other debts in a default and foreclosure.

The Federal Reserve plans to raise short-term interest rates, but to go slow and not very high. Experts say that minimizes the interest-rate risk for mortgage REITs. Even if prices do drift down, investor should have plenty of time to get out.

Shayanfekr, while liking mortgage REITs, says prices could be damaged. "Rising interest rates could lead to a slowing down of the mortgage market and potentially pose the risk of depreciating asset value," he says.

Though many mortgage REITs offer double-digit yields, LaForge says this is a time to remember that, as with most fixed-income holdings, high yields typically signify higher risks. "Our research does indicate that the highest yielding REITs -- often those with the weakest balance sheets -- tend to get hit the hardest performance-wise" as rates go up, he says. "The point is: stay with quality in a rising-rate environment."

What else should investors keep in mind?

"An investor should look especially for regular distributions, conservative loan to value ratios (LTVs), diversification among asset classes, and a strong operations team," Shayanfekr says.

Sbeih says he prefers unleveraged mortgage REITs that invest only the money from investors without additional borrowing.

One strategy widely recommended today is to focus on mortgage REITs owning securities based on adjustable-rate mortgages, since their yields can increase with prevailing rates. "If you are able to invest in a mortgage REIT that primarily features adjustable rates, then it becomes more attractive to invest in a rising market," Sbeih says.

An overview of the REIT market on the Modest Money website advises, "The best kinds of mortgage REITs to own in a rising-rate environment are those that will actually benefit from rising rates." It names Starwood Property Trust ( STWD), yielding 8.52 percent, Ladder Capital ( LADR), yielding 9.09 percent, Jernigan Capital ( JCAP), 6.12 percent, and Ares Commercial Real Estate Corp. ( ACRE) 7.9 percent."

Another option is to invest through a mutual fund or an exchange-traded fund that owns mortgage REITS. The additional layer of fees can be worth it for an investor who doesn't have the time, knowledge or inclination for extensive research, Shayanfekr says.

[Read: Can REITs Survive an Interest Rate Hike?]

One of the big ETF names is iShares Mortgage Real Estate Capped ( REM), yielding about 7 percent and charging a 0.48 expense ratio. It returned about 34 percent over the last year.

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