The coming interest rate hike has increased volatility in the overall real estate investment trust (REIT) sector and left investors to wonder whether to include them in their portfolios going forward.
The high dividend return from REITs is hard to beat in this market and a 25 or 50 basis point increase in interest rates will not be enough offset this appeal. In addition, an entire REIT category with a 10.11% average dividend yield can be hard to argue against.
Mortgage REITs (mREIT) purchase and originate residential and commercial mortgages, as well as residential mortgage-backed securities (RMBS) and commercial mortgage-backed securities (CMBS). Such mREITs aim to profit from their net interest margin – the spread between their borrowing costs and interest income on mortgages.
These kinds of REITs borrow money in the short-term to invest in long-term credit instruments. Plus, mREITs are unlike every other type of REIT in that they do not own any physical assets, only financial instruments.
In a rising rate environment, these kinds of REITs are risky, since they are highly levered and thus interest-rate sensitive. For example, the value of the older mortgage of these REITs will fall when new loans can be originated at higher rates. In this environment, the cost of borrowing rises for all mortgage seekers.
Another downside is that most mREITs do not pay a fixed dividend – the amount paid can vary depending on how well the company is doing. But mREITs typically manage and mitigate this risk through conventional hedging strategies such as interest rate swaps and other financial futures contracts.
Despite the market volatility in the REIT industry caused by concerns over the effects of rising interest rates, mortgage REITs have been the best performing category in the REIT industry in 2016 so far.
Even though residential mREITs have had a better 2016 than their commercial counterparts, commercial mREITs might be an even better investment in the near term. Here’s why:
Residential mREITs: Extreme caution
Residential mREITs earn most of their income through residential mortgages that are insured against default by the U.S. government (through Fannie Mae & Freddie Mac). Because of this insurance, the return on these investments is comparatively low, so it requires higher leverage to maximize return.
Most residential mortgages also are fixed and decline in value as interest rates rise, since newer loans can be made out at higher rates. Residential mREITs thrive in a falling rate environment. To get an idea of how just how interest rate sensitive these kinds of companies are, Annaly Capital (NLY), a $10.5 billion Goliath in the mREIT industry, has projected that a 0.75% rise in interest rates would result in a 6.6% drop in their net asset value.
While there are still companies operating in this area which will do well despite the interest rate rise, I would be extremely cautious entering this particular sub-category in 2017.
Commercial mREITs: Better Bet
Commercial mortgage REITs, on the other hand, invest in or originate commercial mortgages, which have no government backing and thus carry a higher risk. Because of this, the loans are higher yielding and allow commercial mREITs to maximize returns with much lower debt. Moreover, commercial mortgages are usually floating rate loans, rising in conjunction with interest rate which should be profitable for commercial mREITs.
In addition, newer commercial mREITs, those that have gone public since 2008, are fairly different from the older ones. The 2008 crisis and resulting credit crunch forced commercial mREITs to shake up their business model – the newer companies operate with lower leverage, eschew cross collateralization and lend to more favorable loan-to-values ratios.
For those who want to make a commercial mortgage REIT play, consider Apollo Commercial Real Estate Finance Ltd. (ARI). This commercial mREIT originates, acquires, invests and manages commercial first mortgage loans, subordinate financings, commercial mortgage-backed securities and other commercial real estate-related debt investments.
Apollo Commercial offers an impressive 10.3% dividend yield, with five-year historical dividend growth rate at a solid 7.23%. The company’s management has kept the REIT in good financial health coming into 2017 – Apollo Commercial’s tenants have an average of 2.7 years left in their lease, Q3 2016 net margins were at an incredible 50% and sales growth reached 38%. With a debt ratio of only 40%, this REIT could have a great 2017.
Karn Brij is a managing director at an international investment firm with interests in real estate, banking and alternative investments. He specializes in real estate, finance and India-focused investments.