Interest rate risk in mortgage REITs

In several previous posts on mortgage REITs (mREITs) I have discussed the basics of understanding them, that there could be a good investment opportunity in them, and I presented an economic model that breaks down their sources of earnings and dividends. Now, its time to address the very important topic of the risk in investing in mREITs and how an investor can gauge and monitor that risk.

There are three main sources of risk in mREITs; credit risk, liquidity risk, and interest rate risk. Note, that I do not consider the market’s standard definition of risk, volatility, as a source of risk for mREITs. The volatility reflected in the stock prices of mREITs mainly follows from the aforementioned sources of risk. In this post I’ll cover the most important source of risk for mREITs, interest rate risk. The other two I’ll cover in later posts.

Interest rate risk is the big one for mREITs. mREITs primarily make money on the difference between short and long term rates. They borrow short term and invest long term. Today short term rates are very low, long term rates are moderate, and the difference between the two (the interest rate spread) is quite high in historical terms. The risk is that rates move in ways that lower the interest rate spread and lower the value of the investment portfolio of the mREIT, i.e. book value. I’ll spare you the details but the worst thing that can happen to mREITs is that interest rates rise rapidly. A rise in interest rates usually means that interest rate spreads fall (short term rates tend to rise faster than long term rates) and that book values fall (higher long term rates cause the book value of the portfolio to be marked down). During the last rising rate cycle (2003-2005) short term rates rose fast enough and high enough that the yield curve eventually went negative and mREIT profitability went in the tank. Yields on mREITs went from 15% to 4%, due to dividend cuts, and total returns during the 2003 to 2005 period were approximately negative 30%. See chart below.

Dividend rates declined by 80% on average over the interest rate cycle and book values declined by 8%. Needless to say, interest rate rises are something to watch out for unless you plan on holding the investment over the entire interest rate cycle. The best in class mREIT, NLY, has delivered returns of 15% annualized over its entire life which includes two down mortgage cycles. Not bad. However, if the thought of dramatic dividend cuts and price drops during a down mortgage cycle does not suite your investment style then looking out for a period of rising rates is worth it. And the history shows that an investor has time to see the impact of rising rates on mREIT profitability and act accordingly.

An investor can find out what the impact of rising rates are on a particular mREIT by reading the SEC filings. In every 10-Q and 10-K the mREITs publish a table of the effect of changing interests rates on their net income and book value. Before investing in any mREIT this is one of the top metrics to consider. The chart below shows the impact of a 100bp (1%) interest rate increase on the income and book values of various REITs.

Why such a big difference between the various REITs? The difference is due to two factors; the composition of the mortgage portfolios and the differences in hedging strategies. For example, some REITs own more hybrid mortgages or 15 yr mortgages than others so the interest rate impact is less than owning 30 yr mortgages. Also, mREITs use interest rate swaps in different degrees to hedge the impact of short term rates on their profitability. The bottom line is that you can use this information presented in the 10-Qs to judge the impact of rising or falling rates on your investment. As for falling interest rates, that particular scenario is usually positive for net income and for book value for most mREITs but there are exceptions. Consider CIM and TWO in the chart above, their net income would decrease with falling rates.

In summary, when investing in mREITs its important to understand the impact of changing interest rates on your investment. In particular, in today’s environment of high interest rate spreads and low interest rates an investor needs to consider the risk that rising rates could have on their mREIT investment. The general consensus is for interest rates to remain low until the end of the year or early 2012 and then begin a slow rise. mREITS will do well in this environment and should be able to maintain their high yields into 2013. However, there are risks if the interest rate scenario forseen by the consensus proves to be different. Personally, I see rising rates starting later than forecasted due slower economic growth and job gains. Such a scenario would extend the positive run for mREITs. But that’s just my 2 cents.