When mortgage interest rates go up, it’s not just bad news for borrowers. It is also generally bad news for people who invest in mortgage-focused real estate investment trusts or REITs.
Mortgage REITs are specially structured vehicles that invest in mortgages or mortgage securities, while traditional REITs generate income from the rental and sale of real estate. In return for tax breaks, federal law requires REITs to pay dividends to shareholders, making them popular with long-term real estate income investors.
While mortgage REITs can generate high dividends, these trusts also experience “significant price sensitivity to changes in interest rates,” says Tore Steen, CEO of CrowdStreet in Portland, Ore..
âThis was evident in 2018, when mortgage REIT prices fell 4.26%, offsetting the strong dividend performance,â Steen said. “Looking ahead, the question is whether the interest rate hikes have already been incorporated into the price of existing REIT mortgage stocks.”
If investors expect interest rates to rise in the future, mortgage REITs are likely to struggle, but if investors expect rates to fall, mortgage REITs are likely to thrive and will deliver solid returns, says Robert R. Johnson, professor of finance at Creighton University. and co-author of “Invest with the Fed”.
Case in point: Between 1972 and 2013, when interest rates fell, mortgage REITs generated a “robust” annualized return of 19.4%, according to Johnson’s research. But when interest rates rose, mortgage REITs lost 4.1%. And when interest rates were stable, mortgage REITs returned 5.8 percent.
With interest rates set to continue to rise, those who invest in mortgage REITs must be active in their management to outperform. Here are a few things to know about mortgage REITs:
- Avoid REITs focused on single-family mortgages.
- Not all mortgage REITs are created equal.
- Look at the Fed rate hikes.
Avoid single-family residential mortgage REITs
âAs rates continue to rise, affordability becomes a real issue for many consumers, which does not bode well for single-family home prices and, indeed, for single-family REIT performance,â Steen says. .
Steen cites the FTSE Nareit US Real Estate Index, which has reported that single-family REITs have achieved a negative total return of 6.02 percent to date.
And when interest rates rise, individuals and entities holding real estate mortgages “dramatically change their prepayment behavior, which changes the cash flow for holders of mortgage-backed securities,” Johnson explains. They don’t repay the notes or refinance at lower rates like they do when interest rates are lower.
Instead, evaluate investing in other real estate areas, such as healthcare or industry, and look for a mortgage REIT that caters to real estate sectors that have a positive trend.
Not all mortgage REITs are created equal
Some mortgage REITs invest in one type of mortgage, while others may invest in various types of mortgage assets as well as other real estate-related securities, such as AG Mortgage Investment Trust (MITT), which trades at around $ 18.10, down from around $ 16.77 a year ago.
The VanEck Vectors Mortgage REIT Income ETF (MORT) is trading at around $ 23.25, down from around $ 21.74 a year ago. Its main holdings include New Residential Investment Corp. as well as Starwood Property Trust. This exchange-traded fund tracks the MVIS US Mortgage REITs Index, which is made up of companies that earn at least half of their income from mortgages.
Watch the Federal Reserve rate hikes
Since 2015, the Federal Reserve has raised rates seven times and each increase has been 25 basis points – one of the slowest implementations of rate hikes in six decades, says Christopher Totaro, agent at Warburg Realty at New York. This means that it is okay to be bullish on mortgage REITs as long as interest rate increases occur over a period of time that allows REITs to adjust holdings.
When the Fed signals a period of monetary tightening, it raises greater inflationary concerns, which tends to be “relatively favorable for assets less sensitive to interest rate fluctuations, such as equity REITs,” said Johnson.
Rental rates for apartments, warehouses and office buildings tend to adjust to changes in inflation, which reduces the sensitivity of equity REITs to inflationary pressures and makes these securities relatively attractive to those investing in stocks. real estate during this period, Johnson adds.
Mortgage REITs are also very heavily leveraged, which means that an increase in interest rates leads to an immediate increase in spending, Johnson says.
Investing in real estate is a way for investors to diversify their portfolios and long-term investors are drawn to the concentration and dividends offered in REITs.