Will Mortgage Rate Cuts Lead To Better Days For Mortgage REITs?

Aside from would-be homebuyers, no segment of the real estate industry has been put under more pressure by the Fed's rate hikes than mortgage REITs. As a much-anticipated interest rate cut appears on the horizon, Benzinga looks at whether it could be just the tonic the mortgage REIT sector needs and how that might affect REIT investors.

When market conditions are favorable, mortgage real estate investment trusts (mREITs) offer investors an appealing package of dividend yield and reliable performance. Some of the highest-performing mREITs can offer double-digit dividends and returns like manna from Heaven for investors. Unfortunately, the variables and market fundamentals that allow mREITs to pay those high dividends are very sensitive to interest rates.

Trending Now:

• Investing in private credit could potentially unlock APY up to 20%, with benefits like shorter term durations and diversified returns – Find out more if you're an accredited investor.
• Commercial real estate has historically outperformed the stock market. This platform allows accredited investors to invest in commercial real estate, invest today for a 1% boost.

MREITs operate by purchasing large tranches of mortgage-backed securities (MBS) with investor capital and aggressive borrowing. Asset sales and interest on the MBSs in the mREIT portfolio generate the returns. The good thing for investors is that the loans in mREIT portfolios are secured by real estate, which makes them (comparatively) lower-risk investments than other stocks and securities with similar share prices. However, that doesn't mean mREITs are without risk.

They borrow aggressively to purchase as many MBS portfolios as possible. This strategy increases the probability of returns but raises risks because part of that aggressive borrowing involves short-term financing. That works as long as the mREIT can borrow capital or refinance its debts at lower rates than the loans in the mREIT's portfolio. This is the potential weak link in the mREIT profit chain.

A typical mREIT's ability to function heavily depends on its ability to borrow capital at low interest rates. MREITs can easily find themselves on the wrong side of the math when rates increase. Imagine an mREIT that borrows money at 2.5% to buy $30 million worth of mortgages paying an average rate of 4%. That's a winning deal. Imagine the mREIT leveraging more debt on short-term loans to buy more MBSs.

That would allow the mREIT to buy more loan portfolios for the same initial investment, increasing dividends. Theoretically, the mREIT could refinance the remaining debt before the initial loan term expires. However, if interest rates go up to 3.5% and then 4%, the mREIT's dividends on that particular loan portfolio would shrink and disappear when the mREIT looks to pay or refinance its debt.

That is why the Fed's rate increases have unsettled the mREIT sector. The borrowing capital they had access to for almost a decade after the great financial crisis suddenly costs twice as much. This has left some portions of mREIT portfolios upside down because the mortgages pay rates equal to or less than the interest rates that the mREIT can refinance.

Read More:

• Investor alert: Triple-net properties can put a check in your pocket every quarter—a can’t-miss opportunity for accredited investors.
• Oprah, Madonna and DiCaprio have turned to the alternative asset that is outperforming the S&P 500. Discover the potential of this market before other investors.

That's why mREIT fund managers and investors alike have eagerly anticipated an interest-rate cut. Some are hopeful for a second-rate cut this year. The second cut this year looks less likely. Still, the first expected cut in September has mREIT investors and fund managers in a state of anticipation reminiscent of children wondering what's inside a wrapped gift they can't open until their birthday or Christmas.

Regardless of what the rate cut is or how many times rates are cut in the next 12-24 months, anyone involved with the mREIT sector will warmly welcome every cut. Lowered borrowing costs are always a boon to mREITs and their shareholders. So, while there will likely be an uptick in performance for some mREITs, they'll still need to proceed with caution.

A recent quote from mREIT and ETF operator VanEck in an ETF Trends blog sums up the state of the market: "Mortgage REITs must balance pursuing high-interest income and potential capital gains with managing associated risks. This balance is key to sustaining profitability, especially in fluctuating economic conditions. Strategies include diversification of the mortgage portfolio, careful credit analysis, and hedging against interest rate changes."

So, in a word, the interest rate cuts certainly have the potential to add some positive juice to the mREIT sector. This will undoubtedly bring investors back as well, but the long-term winners will be the mREITS that successfully straddle the line between being overly cautious and overly aggressive. Keep an eye out for opportunities in this sector.

Today's Best Finance Deals

 A 9% Return In Just 3 Months

EquityMultiple's ‘Alpine Note — Basecamp Series' is turning heads and opening wallets. This short-term note investment offers investors a 9% rate of return (APY) with just a 3 month term and $5K minimum. The Basecamp rate is at a significant spread to t-bills. This healthy rate of return won't last long. With the Fed poised to cut interest rates in the near future, now could be the time to lock in a favorable rate of return with a flexible, relatively liquid investment option. 

What's more, Alpine Note — Basecamp can be rolled into another Alpine Note for compounding returns, or into another of EquityMultiple's rigorously vetted real estate investments, which also carry a minimum investment of just $5K. Basecamp is exclusively open to new investors on the EquityMultiple platform.

Looking for fractional real estate investment opportunities? The Benzinga Real Estate Screener features the latest offerings.