Are mortgage REITs' 13% yield worth the risk?

By Covestor

mortgage-reit

Some mortgage REITs are paying out hefty yields but investors tempted to venture into this esoteric sector should be mindful of the risks, especially the potential impact of rising interest rates.

These real estate investment trusts (REITs) generally borrow using short-term loans to finance purchases of mortgage-backed securities.

"Mortgage REITs are a polarizing asset, either loved (for their yield) or avoided (for their risk) by investors," says Morningstar analyst Abby Woodham in a note. "Mortgage REITs’ double-digit yield, while attractive, is a flashing signal that this subsector is only appropriate for very risk-tolerant investors."

For example, the iShares Mortgage REIT Capped ETF (REM) is paying a 30-day SEC yield of about 13%.

REM Chart

REM data by YCharts

Sherman Lee currently owns iShares Mortgage REIT Capped ETF in the Prudent Value portfolio on the Covestor platform, and recently spoke about the sector's opportunities and risks.

Mortgage REITs fell sharply during the spring of 2013, which illustrates their sensitivity to rising interest rates. They also took a hit last year as investors positioned for the Federal Reserve to scale back its purchases of mortgages. The central bank has been buying Treasuries and mortgages after the financial crisis to keep rates low and stimulate the economy and housing market. However, the Fed has started tapering its bond purchases.

"Mortgage REITs are paying big yields, but there is definitely risk there because the companies are leveraged," Lee said.

Aside from iShares Mortgage REIT Capped ETF, he also owns an individual mortgage REIT in the portfolio: Annaly Capital Management (NLY). The stock is paying a yield of more than 10%.

Lee said Annaly Capital and other mortgage REITs make money on the spread between short-term rates and the yield from the mortgages they invest in.

The sector is highly susceptible to rising rate risk. Mortgage REITs cut their distributions and performed poorly during past rising rate environments, said Woodham, the Morningstar analyst.

Indeed, Lee noted that Annaly Capital and some other mortgage REITs have lowered their distributions recently and are deleveraging. Still, the sector's reliance on short-term funding means the firms are sensitive to changes in interest rates, credit markets and Fed monetary policy. Some mortgage REITs attempt to hedge their interest-rate risk with derivatives, Lee added.

Another risk investors need to keep in mind with mortgage REITs is so-called prepayment risk, generally when interest rates fall.

"When borrowers refinance into a loan with a lower rate, that can lower the income that mortgage REITs receive," Lee said.

Also, many mortgage REITs buy mortgage-backed securities guaranteed by Fannie Mae (FNMA) and Freddie Mac (FMCC). The two companies were taken over by the government and placed into conservatorship during the credit crisis. Recently though, there has been talking of winding them down or privatizing the companies.

The bottom line is that investors should carefully consider the risks before chasing the high yields of mortgage REITs.

"Overall, I see mortgage REITs as a good yield play and a good portfolio diversifier," Lee said. "A small allocation to mortgage REITs is a reasonable strategy, although you definitely don't want to put all your eggs in this risky basket."

Photo Credit: Daquella manera

DISCLAIMER: The investments discussed are held in client accounts as of January 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. REITs are subject to illiquidity, credit and interest rate risks, as well as risks associated with small- and mid-cap investments. Past performance is no guarantee of future results.