Real estate assets, including exchange traded funds tracking real estate investment trusts (REITs), have struggled since the group was separated from the financial services sector in the third quarter of 2016. The Federal Reserve hiking interest rates in December and the notion that more rate increases are on the way this year is also weighing on rate-sensitive real estate equities.
The high-yielding iShares Mortgage Real Estate Capped ETF (NYSEArca: REM) and the rival Market Vectors Mortgage REIT Income ETF (NYSEArca: MORT) are among the real estate-related ETFs that could defy common rate logic.
Mortgage REITs have exhibited a negative correlation to interest rates changes, especially if the yield curve flattens. Many agencies use leverage to capitalize on the arbitrage spread between short- and long-term interest rates, so companies can still make money in a rising rate environment, as long as long-term rates rise faster than the short-term rate or if the yield curve steepens.
“A view that interest rates were going to move higher should at least have applied the brakes to any rally in this sector. But the trend since last October continues to be to the upside, and the long-term view shows prices now bumping up against a strong resistance ceiling that supported interim lows over the past few years — including the bottom of the 2008 financial crisis debacle,” reports Michael Kahn of Barron’s on REM.
Mortgage REITs rely on short-term loans, so costs could rise if short-term rates suddenly spike. However, the negative effect of higher short-term rates could be somewhat offset by quickly rising long-term rates as mREITs benefit from a steeper yield curve and arbitrage the wider spread.
Conventional wisdom dictates that higher interest rates diminish the chances that homeowners will refinance their mortgage rates. Additionally, many mortgage REITs did not anticipate the sharp spike in interest rates and the result was a rash of dividend cuts from REM and MORT holdings.
For a more diversified approach to REITs, investors can tap ETFs such as the Vanguard REIT ETF (NYSEArca: VNQ), the largest REIT ETF.
VNQ “holds a more-diversified group of REITs in hotel, office, residential, and other areas, is also on the verge of an upside breakout, albeit one not as significant. Still, a short-term chart shows that a move through resistance could target last year’s highs and the double-digit percentage gains of the next few months,” according to Barron’s.
For more information on real estate investment trusts, visit our REITs category.