Mortgage real estate investment trusts (REITs) are a special and niche type of REITs that does not purchase buildings, malls or other properties. Rather, mortgage REITs invest in real estate debt. In general, mortgage REITs generate revenues by borrowing short-term to purchase long-term mortgage-backed securities, or MBS.
Moreover, some mortgage REITs are highly leveraged, making them highly susceptible to large drops, if and when interest rates rise. This is primarily due to the fact that the value of a mortgage REIT’s holdings will fall, while its funding costs rise. On the other hand, even if rates fall, mortgage REITs could get pummeled, since the mortgages could get prepaid at a lower rate, and if they’re not properly hedged, it would hurt the REIT’s value.
The Fed Could Raise Rates This Month, and Some Mortgage REITs Could Fall
Now, mortgage REITs’ profit margins are highly sensitive to the shape of the yield curve. When the shape of the yield curve is very steep, when short-term rates are low and longer-term rates are high, mortgage REITs earn a bigger spread. However, the shape of the yield curve could change if the Fed raises rates in its March meeting.
Here’s a look at the Treasury Yield Curve on March 2, 2016.
Source: U.S. Department of Treasury
However, the Fed has already indicated any meeting could be live. Federal Reserve Chair Janet Yellen increased the probability of interest rate hikes, as early as the FOMC meeting in March. According to Yellen, “At our upcoming meetings, the Committee will evaluate whether employment and inflation are continuing to evolve in line with these expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.”
With that in mind, the market seems to be taking this heavily and the CME Group 30-Day Fed Fund futures prices indicated that there was a 75.3% chance that the Fed would raise rates on March 15, 2017. Consequently, there was a mere 24.7% chance that rates would remain unchanged at the next FOMC meeting.
Source: CME Group
Potential Flattening of Yield Curve Could Hurt Mortgage REITs
Now, that means that the yield curve will flatten. That’s bad news for mortgage REITs. As the yield curve flattens, the amount they earn for the spreads could be minimal. This could hurt mortgage REITs’ price performance/
That being said, there is one stock and one ETF that could fall if the Fed raises rates. Manhattan Bridge Capital Inc (NASDAQ: LOAN) is one stock that could be hurt in the event that the Fed raises rates multiple times in 2017. Since LOAN is highly affected by movements in interest rates, the stock’s earnings can fluctuate significantly. Now, if you don’t recall, REITs must pay 90% of their taxable incomes to their shareholders each year. If the Fed raises rates multiple times in 2017, the yield curve will continue to flatten, which could hurt LOAN’s earnings. That means a lower payout to investors, or potentially no payout if it reports an earnings loss.
This would be reminiscent of 2015, when the shape of the yield curve flattened due to the increased probability of Fed rate hike. Now, at the time, the iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM), which provides export to both the U.S. residential and commercial mortgage real estate industries, experienced some volatility when the yield curve began flattening in 2015. REM was highly sensitive to rising interest rates. In June 2015, when the two-year Treasury yield increased by 6%, and it fell by 9%.
That being said, with the increased probability of rate hike, both REM and LOAN could fall significantly. Due to the increased probability of a rate hike, LOAN was down over 10% over the past three months, and nearly 20% YTD, as of March 2, 2017. LOAN has been underperforming REM, which could be viewed as a benchmark. Now, REM was up 9.16% over the past three months and YTD.
The Bottom Line
If the Fed raises rates, it could be bad news for the mortgage REIT industry. A rising interest rate environment would flatten the yield curve, and that could hurt mortgage REIT’s earnings. Keep an eye on the FOMC meeting on March 14-March 15, 2017, to see whether they’ve voted for a rate hike. Now, if there is a rate hike, LOAN and REM should fall.