When mortgage interest rates go up, it's not just bad news for borrowers. It's also usually unwelcome 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, whereas traditional REITs generate income from property rents and sales. In return for tax breaks, federal law requires REITs to pay dividends to shareholders, which makes them popular with long-term real estate income investors.
While mortgage REITs can generate high dividend performance, these trusts also experience "significant price sensitivity to changes in interest rates," says Tore Steen, CEO of CrowdStreet in Portland, Oregon.
"This was apparent in 2018 when mortgage REITs prices declined 4.26 percent, negating strong dividend performance," Steen says. "Looking forward, it's a matter of whether interest rate hikes have already been baked into existing mortgage REIT share prices."
If investors expect interest rates to rise in the future, it is likely that mortgage REITs will struggle, but if investors expect rates to fall, mortgage REITs will likely prosper and provide robust returns, says Robert R. Johnson, professor of finance at Creighton University and co-author of "Invest with the Fed."
Case in point: between 1972 through 2013, when interest rates were falling, mortgage REITs returned a "robust" 19.4 percent annualized return, according to Johnson's research. But when interest rates were rising, mortgage REITs lost 4.1 percent. And when interest rates were flat, mortgage REITs returned 5.8 percent.
With interest rates expected to continue their shift upward, people investing in mortgage REITs need to 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.
-- Watch Fed rate hikes.
Avoid Single-Family Residential-Focused Mortgage REITs
"As rates continue to rise, affordability becomes a real issue for many consumers, which won't bode well for single-family home prices, and, effectively, single-family REITs performance," Steen says.
Steen cites the FTSE Nareit U.S. Real Estate Index, which reported that single-family REITs achieved a negative total return of 6.02 percent to date.
And when interest rates go up, individuals and entities holding real estate mortgages "significantly alter their prepayment behavior, which changes the cash flows to holders of mortgage-backed securities," Johnson says. They don't pay off the notes and refinance at lower rates like they do when interest rates are lower.
Instead, evaluate investing in other real estate areas, such as in health care or industrial, and seek a mortgage REIT that caters to real estate sectors that are trending positively.
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 the AG Mortgage Investment Trust (MITT), which is trading at about $18.10, up from about $16.77 a year ago.
VanEck Vectors Mortgage REIT Income ETF ( MORT) is trading at about $23.25, up from about $21.74 a year ago. Its top holdings include New Residential Investment Corp. as well as Starwood Property Trust. This exchange-traded fund tracks the MVIS U.S. mortgage REITs index, which is made up of companies that derive at least half of their revenues from mortgages.
Watch Federal Reserve Rate Hikes
Since 2015, the Federal Reserve has raised rates seven times and each increase was 25 basis points -- one of the slowest implementations of rate hikes seen in six decades, says Christopher Totaro, an agent with Warburg Realty in New York. This means that it's OK to be bullish on mortgage REITs as long as the interest rate increases occur over a period of time that allows for REITS to adjust holdings.
When the Fed signals a tight money period, it incites greater inflationary concerns, which tends to be "relatively favorable for assets that are less sensitive to shifting interest rates, such as equity REITs," Johnson says.
Rental rates on apartments, warehouses, and office buildings tend to adjust with shifts in inflation, and this reduces the sensitivity of equity REITs to inflationary pressures and makes these securities relatively attractive to those investing in real estate during this time, Johnson adds.
Mortgage REITs are also very heavily leveraged, which which means an increase in interest rates results in an immediate increase in expense, Johnson says.
Investing in real estate is one way investors can diversify their portfolios and long-term investors are attracted by the focus and dividends offered in REITs.
Kayleigh Kulp is a freelance journalist who also writes or has written for CNBC, The Daily Beast, Afar, the Washington Post, Travel Channel, Travel + Leisure, CNN, Fox Business Network, Wine Enthusiast, The Daily Meal, Los Angeles Times, Bust, AARP and AAA Journey magazines, ABC News, Miami Herald, San Antonio Express-News, Washington Examiner and The Baltimore Sun.