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ETF Specialist

No Surprises Here: Mortgage REITs Stumble

Although this ETF offers almost unparalleled yield, it comes with significant risk.

Mortgage REITs are a polarizing asset, either loved (for their yield) or despised (for their risk) by investors. The bears must be feeling vindicated now, as the market's emotional response to the Fed's recent announcements sent  iShares Mortgage Real Estate Capped (REM) into a nosedive since the beginning of April. REM lost a stomach-churning 19% over the past three months, driven by instability in the yield curve and falling book values. For investors considering an allocation to REM, the sharp decline of mortgage REITs over recent months should serve as a reminder of this asset's high risk profile. Mortgage REITs' double-digit yield, while attractive, is a flashing signal that this subsector is only appropriate for very risk-tolerant investors willing to make a bet on future rates. On the upside, mortgage REIT valuation is fast approaching post-2008 discount levels.

Not to be confused with equity REITs, which generate income by managing properties and collecting rent, mortgage REITs are financial firms that arbitrage the spread between the short-term interest rate and income from mortgage-backed securities. Mortgage REITs do not have access to deposit funding, so they rely on short-term loans like repurchase agreements. The largest firms purchase federally guaranteed securities from Freddie Mac and Fannie Mae.

REM can look deceptively low-risk because it has been less volatile than both the S&P 500 and equity REITs since the financial crisis. However, this was largely due to the subsector's stagnation until 2012. Unlike equity REITs, which quickly rebounded from the 2008 crash, mortgage REITs faced a very gradual recovery. Investors, spooked by the meltdown in 2008, have kept mortgage REIT prices near their low post-crash level. REM's swift fall highlights the risk that was always present: changing rates.

Uncertainty Rules
Mortgage REITs are very susceptible to the risk of rising short-term rates. Until recently, mortgage REITs have benefited from the Fed's easy money policy. The Fed's historically low near-zero interest rate makes financing cheap, allowing mortgage REITs to use leverage to provide an attractive yield. However, because these firms are so extensively leveraged, they are very susceptible to interest-rate fluctuations. The majority of mortgage REIT financing is as short term as 30 days, so if the capital markets freeze, these firms could be forced to accept unfavorable terms. Lenders also can make margin calls following a market decline. Either situation could force mortgage REITs to raise capital through share issuance. Many of these firms use interest-rate swaps to try to hedge these risks.

Even the whisper of changing rates can send the market into a panic, as seen over the past three months as REM lost more than 19%. We expect interest rates to remain low in the near term, but even small upticks in the short-term rate can have a significant impact on these firms' profitability and dividends. Historical evidence is not encouraging: Mortgage REITs cut their distributions and performed poorly during past rising rate environments. REM's two major holdings, Annaly Capital Management (NLY) (17.5% of assets) and American Capital Agency (AGNC) (13%), unsurprisingly cut their distributions even further in June after continued sell-offs. Both companies reduced their dividends last year as well. Because REM's distributions (which are more volatile than payouts from equity REITs or the broad market) account for as much as 80% of the fund's total return, declines in payouts considerably reduce return.

The massive sell-off of mortgage REITs in recent weeks has been largely driven by uncertainty, as increases to both the short- and long-term rate are now on the table, which have both positive and negative effects on mortgage REITs. An increase in the short-term rate will raise funding costs, but if long-term rates rise faster, the yield curve will steepen, which would improve the spread. However, rising long-term rates weigh on the book value of existing mortgage REITs. Changes to the Fed's purchasing program are also a concern. The Fed's third round of quantitative easing has included aggressive purchasing of mortgages, which drove the price of mortgage-backed securities higher over the last year. An anticipated slowdown in Fed purchases could result in lower demand for mortgage securities, and falling prices.

One major risk that may be winding down is prepayment. Easy access to cheap financing drove mortgage rates to historic lows over the past few years, driving homeowners to refinance at the newer, more attractive rates. Prepayment means that high-yielding mortgages get called, forcing REITs to reinvest in less attractive ones. With mortgage rates on their way up now, prepayment should become less of a problem.

Portfolio Construction
REM tracks the FTSE NAREIT All Mortgage Capped Index. The index is weighted by market cap and screens constituents for size and liquidity. Most of REM's holdings are medium- and small-cap. REM has large allocations to two mortgage REITs, Annaly Capital Management and American Capital Agency. These companies invest exclusively in agency-backed mortgages. REM tracked the uncapped version of its index before 2009, which led to significant tracking error; Annaly and American Capital each made up more than 25% of the uncapped index, but IRS rules stipulate that exchange-traded funds are not allowed to own more than 25% of their portfolio in a single security. After switching to the capped index in 2009, REM has tracked its index closely.

If you have the option, both mortgage and equity REITs should be held in a tax-advantaged account because most of their dividends are taxed as income, not as qualified dividends. The unfavorable tax treatment arises from the REIT legal structure, which, in exchange for no taxation at the company level, obliges the firms to pass on the majority of their earnings (and taxes) to shareholders.

REM charges 0.48% a year, which is expensive compared with equity REIT ETFs but average for funds that include mortgage REITs.

There are very few alternatives to REM. Until the 2011 launch of the Market Vectors Mortgage REIT ETF (MORT), REM was the only exchange-traded mortgage REIT product available. MORT costs 0.40% a year.

An alternative to REM is  iShares Dow Jones U.S. Real Estate (IYR), which is the only large REIT ETF to include all REITs. Most indexes exclude REITs that derive the majority of their income from non-real estate activities, a category that contains mortgage, prison, and timber REITs. IYR includes these REITs, which make up about 20% of its holdings. These firms are exposed to economic factors other than the real estate market. IYR is the most liquid REIT ETF, averaging a daily trading volume of more than 7 million, but it's expensive at 0.47% a year. With inexpensive alternatives to pick from, the cost is difficult to justify.

Our favorite equity REIT ETF is  Vanguard REIT Index ETF (VNQ), which charges 0.10% a year. We like VNQ's low fees, size, and comprehensive coverage of the REIT sector. VNQ's 120-plus holdings include more mid- and small-cap stocks than most competitors. This fund offers broad, and among the cheapest, exposure to the domestic real estate market.

Only  Schwab US REIT ETF (SCHH) can challenge VNQ's low price. It charges just 0.07% for very similar holdings and performance. SCHH excludes the smaller REITs present in VNQ's portfolio, but 90% of their holdings overlap. We prefer VNQ's broader selection of REITs, but SCHH is an excellent alternative. SCHH tracks the same index as  SPDR Dow Jones REIT (RWR), which charges 0.25%.


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Abby Woodham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.