Mortgage REITs are not REITs- avoid them like the plague

Mortgage REITs are a good way to lose all your money

Times are tough. Investors are searching for yield. In these inflationary times, any extra income- from a side hustle to a few hundred dollars of dividend income- is much appreciated. It pays for a tank of gas or a week's worth of groceries.

REITs are a natural way to generate income in inflationary times. They throw off a lot of income- and the underlying real estate assets tend to appreciate during inflationary periods. When inflation strikes, hard assets such as gold and real estate hold their value in real terms. It's the money that loses value, not the hard asset.

Investors screening for stocks may stumble upon a category of REITS generating very high yields. These REITS are currently generating close to 20% yields. Some are even higher!

The only problem is: they aren't really REITS. And their yield comes at a terrible price in risk.

This category of REITS are "Mortgage Reits," or mREITS. They are not traditional REITS that own physical property such as apartment buildings and warehouses. In fact, calling them REITS at all is a bit of a fraud.

Mortgage REITS own mortgages. They don't own physical property. Rather, they own mortgages and mortgage-backed securities.

Mortgage REITS are not REITS at all. They are miniature hedge funds.

How does an mREIT generate such incredible yields of 20% or more, when the average mortgage only yields 5% or 7%? Simple: they use leverage, and plenty of it.

These mini hedge funds employ all the "risk management" techniques of hedge funds such as swaps, interest rate hedges, and shorting. They use leverage to own a huge pool of mortgages based on a tiny sliver of equity capital. (If that reminds you of Lehman Brothers or AIG back in 2008, it should.)

The sky-high yields offered by mREITS are illusory. They come at the cost of significant risk of loss of capital. In the worst case scenario, mREITS go bust entirely.

In the 2008 financial crisis, three of the largest mREITS went bankrupt: New Century Financial, American Home Mortgage, and HomeBanc Corp. They went from titans of Wall Street with billion dollar market caps, to zeroes- almost overnight. Every penny of investor capital was wiped out.

Like 2008, we are entering a period of economic uncertainty. The Fed is hiking rates. There may be another Lehman or AIG lurking out there somewhere to put a hole in the global financial system, just like 2008.

Mortgage REITS are one of the worst possible things you could ever own. Ironically, they are stealing the REIT name from one of the best asset classes for long-term investors. Make sure you know the difference between a real REIT and a mortgage REIT, and avoid the latter completely.