If you follow real estate investment trusts (REITs), and especially those that invest in mortgages, you're probably wary of rising interest rates. These mREITs have profited by borrowing money at current ultra-low rates, investing in mortgage-based securities, and enjoying the "spread" between the former's cost and the latter's more generous returns. As borrowing costs rise, this gravy train will likely to dry up, to some degree. But there's an often overlooked upside to rising interest rates: falling prepayments.
First, let's take a gander at the gravy train. Since REITs are required to pay out at least 90% of their earnings in dividend form, they can have quite high payouts. Some of their current dividends look downright astonishing:
Market Capitalization (in millions)
American Capital Agency (NAS: AGNC)
Invesco Mortgage Capital (NYS: IVR)
Cypress Sharpridge Investments (NYS: CYS)
Resource Capital (NYS: RSO)
Chimera (NYS: CIM)
Two Harbors Investment (ASE: TWO)
Annaly Capital (NYS: NLY)
Source: Yahoo! Finance.
But these huge dividends aren't always as attractive as they seem. The inevitability of higher interest rates threatens all of the payouts above.
The danger of prepayments
However, recent years' falling rates have also challenged these companies. For quite a while now, Americans have been busy refinancing their mortgages. As interest rates have fallen, people with expensive loans have been able to refinance more cheaply, getting new loans that pay off their old ones. While that's great news for the borrower, it's much less fun for the lender, who now gets to collect less in interest payments over the next few years or decades. It's not so hot for the mREIT (mortgage-focused REIT) that invested in that refinanced mortgage, either.
At least when rates rise, these kinds of prepayments aren't as common. High rates discourage refinancing, letting more mortgages run their course, or at least last longer, thus delivering more consistent interest -- even if it comes at lower rates.
If you're considering mREIT investments, make sure you weigh the risks of interest-rate changes, and be sure to examine factors such as their assets-to-equity ratios, the riskiness of their mortgage portfolios, the trustworthiness of management, and the prepayment rates they're experiencing.
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