REM: High Yield But High Risk – iShares Mortgage Real Estate Capped ETF (BATS:REM)

ETF Overview

iShares Mortgage Real Estate Capped ETF (REM) owns a portfolio of mortgage REITs in the U.S. The fund tracks the FTSE NAREIT All Mortgage Capped Index. REM’s portfolio of mREITs is generally sensitive to the difference between short-term and long-term interest rates. Although its dividend yield of nearly 9% is attractive, the nature of mREITs’ high payout ratio makes REM’s dividend vulnerable. Therefore, we expect dividend cuts when its net interest margin compresses or even turns negative. Since we are already in the latter stage of the current economic cycle, we think investors may want to wait on the sidelines.

Data by YCharts

Fund Analysis

High sensitivity to interest rate changes

Mortgage REITs provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities (MBS) and earning income from the interest on these investments. Like many other financial institutions, mREITs also face interest rate risks. The success of an mREIT depends on its ability to acquire assets at favorable spreads over borrowing costs.

In such an environment, if an mREIT’s average short-term interest rate is higher than the average long-term rates on its mortgage-backed securities, its NIM will become negative. This means the mREIT will be losing money. On the other hand, if the average short-term interest rate is lower than the average long-term rates, its NIM will remain positive and the company will have a positive net income.

Readers may wonder why we are bringing this in our discussion. The answer is because we have recently seen a yield inversion where the short-term rate is higher than the long-term rate. As can be seen from the chart below, the spread between the 10-year treasury yield and 3-month treasury yield has turned negative since late May 2019. It has since stayed below zero. This is called yield inversion. In this rate environment, it will be quite challenging for mREITs in REM’s portfolio to maintain positive NIMs.

Source: Federal Reserve Bank of St. Louis

High dividend yields but vulnerable

Since mREITs are required to pay 90% of their taxable income to their shareholders in the form of distribution, their dividend yields are usually much higher than other equities’. Therefore, REM pays a generous dividend yield. As can be seen from the chart below, REM has a dividend yield of nearly 9%.

Data by YCharts

Despite its high dividend yield, we believe REM’s dividend is vulnerable when its NIM continues to compress. The following chart illustrates the impact of a flattening yield curve on REM’s dividend. A flattening yield curve is similar to NIM compression of an mREIT. As can be seen from the chart, as the yield curve (red line) flattens, REM’s dividend gradually declines as well (orange line). This is because mREITs in REM’s portfolio have high payout ratios. Therefore, as its net interest income declines, it has no other way except to also cut its dividend in order to keep its payout ratio below 100%.

Data by YCharts

Management expense comparable to other similar ETFs

REM charges a management expense ratio of 0.485% a year. This is expensive compared to equity REIT ETFs. However, it is comparable to other mREITs. VanEck Vectors Mortgage REIT Income ETF (MORT) has a MER of 0.41%. This is slightly less than REM’s 0.485%. MORT’s lower cost appears to be advantageous as over the span of 9 years, it delivers a total return of 106%. This is higher than REM’s 96.6%.

Data by YCharts

Macroeconomic analysis

The current economic cycle has been well into its 10^th year. However, the U.S. ISM Manufacturing PMI has fallen from the high of over 60 in 2018 to only 51.2 in July 2019. This leading economic indicator is telling us that the strength of the economy has gradually been weakened. In addition, the uncertainties surrounding global trade tensions have the potential to derail the U.S. economy. Some financial institutions such as Morgan Stanley (NYSE:MS) even think that a recession could arrive in 3 quarters if trade war continues to escalate. As we have discussed earlier in the article, the yield spread (U.S. 10-year treasury yield minus 3-month yield) has recently been inverted. This is not good news for mREITs as they make money by borrowing at short-term lending rates and lending out at longer-term rates. Therefore, we do not see this environment as favorable for mREIT ETFs such as REM.

Investor Takeaway

Although REM has an attractive dividend yield of nearly 9%, we do not think REM’s portfolio of mREITs will perform well when the yield has inverted. Since we are already in the latter stage of the current economic cycle, we do not see the risk/reward profile compelling. Therefore, we think investors should wait on the sidelines until the beginning of the next economic cycle.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.