The unexpected fall in interest rates this year has helped high-yield real estate investment trust exchange traded funds generate strong gains, and with the Fed maintaining low rates, the sector may still have room to run.
As benchmark Treasury yields dipped to 2.45% from 3.0% at the start of the year, REITs have provided investors with an attractive yield-generating alternative.
For example, the Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) has increased 14.6% year-to-date while the iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) gained 14.7%. REM shows a 15.5% 12-month yield and MORT has a 13.18% 12-month yield.
KBW analyst Michael Widner. argues that investors who believe rates will remain subdued in the short-term can stick to mortgage REITs that utilize agency mortgage-backed securities, reports Philip van Doorn for MarketWatch. [Rate-Sensitive REIT ETFs Rebound]
Both MORT and REM include heavy allocations toward Annaly Capital and American Capital Agency, which both invest exclusively in agency-backed mortgages. REM’s top holdings include Annaly Capital Management (NYSE: NLY) 15.0%, American Capital Agency Corp (NYSE: AGNC) 11.4% and Northstar Realty Finance Corp (NYSE: NRF) 8.1%. MORT’s top holdings include NLY 17.8%, AGNC 13.0% and NRF 8.0%.
“The caveat is you have to be comfortable that rates aren’t going up,” Widner said in the article.
The Federal Reserve has already indicated that it won’t allow the federal fund rate to rise until the middle of 2015, so investors still have some wiggle room. [Rate Relief for mREIT ETFs]
Potential investors should be aware that REITs are vulnerable to a rising rate environment. Certain REITs, notably mortgage-backed securities, have to be marked to market as rates rise, which lead to losses. Additionally, REITs see higher costs as rates increase.
“Mortgage REITs are financial firms that engage in arbitrage on the spread between the short-term interest rate and income from mortgage-backed securities,” according to Moringstar analyst Abby Woodham.
Consequently, the arbitrage opportunity dwindles as rates rise and the spread dwindles, which causes REITs to lose profits.
For more information on real estate investment trusts, visit our REITs category.
Max Chen contributed to this article.