How to Profit from Falling Interest Rates
Updated: Sep 19, 2019
As interest rates decline, there is an asset that profits from this situation. Learn how to create passive income each month using mortgage REITs that are positioned to increase investing profits.
With yields on 10-year US Treasury notes having fallen below yields on 2-year notes for the first time since 2007, the phrase "inverted yield curve" has found its way back into investors' conversations. It's unusual for yields on fixed income securities that mature in the relatively near future to be higher than on those that mature at a more distant point in time, but it's not the first time this year it's happened. Yields on 3-month Treasury securities moved higher than those on 10-year notes earlier in 2019.
Conventional wisdom says that when the curve inverts, a recession is drawing near. But history shows that an inverted yield curve forecasts recession much in the same way that autumn forecasts winter: While one eventually follows the other, nothing indicates precisely when it will happen—or what to do about it. What an inverted yield curve does tell investors is that they should be cautious.
One of the better investments for falling interest rates is REITs. You can make big returns in this area as investors flock into REITs for yield plays.
Two Types of REITs
Most of the REITs operate as equity types compared to their smaller peers in the mortgage REIT (mREIT) sector.
The majority of REITs operate as equity REITs, providing investors access to diverse portfolios of income-producing assets they would not be able to afford on their own. These real estate companies own properties in a range of real estate sectors that are leased to tenants, such as office buildings, shopping centers, apartment complexes, storage and more. They distribute the bulk of their income to shareholders in the form of dividends.
Mortgage REITs (mREITS) provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities and earning income from the interest on these investments. mREITs tend to provide high yield investments which is favorable to income seeking investors.
Tax-advantages of REITs
REITs must distribute at least 90% of their income annually as dividends. Because REITs don’t pay corporate tax, more of their earnings is passed on as dividends to investors, who are taxed on that income.
Until 2018, REIT dividends were taxed at the individual shareholder’s ordinary rate. That was unlike corporate dividends, which were taxed at a lower rate if the investor held the shares for a set period. That meant that although REIT dividend yields were much higher than for most corporations, they tended to attract a higher tax rate.
But starting in 2018, REIT dividends enjoyed a whole new tax benefit that is normally reserved for a select few taxpayers. Under the Act, the owners of pass-throughs don’t pay any tax at all on 20% of those profits. And here’s the great thing: REITs are officially considered pass-throughs. If you own shares in a REIT, 20% of your dividend income is exempt from taxation.
This 20% pass-through deduction reduces the tax rate on REIT dividends making them more tax friendly than other investments.
The key thing is when you own a REIT, it’s no different from owning the real estate yourself and maybe having a real estate manager own it for you. Essentially, when you buy shares in a REIT, you’re becoming a partner in a huge real estate partnership. You own your share of that real estate just as much as you would if you owned the building itself. Because you’re an owner, you participate fully in the gains from real estate ownership. The managers of REITs — the executives who run them — cannot play the kind of games with manipulating share prices or dividends that you often see in the corporate sector because they have to comply with tax laws. The tax laws say that most of the income of REITs have to be distributed to you.
Now, here are six reasons why I like them and why I think you will too:
1. Businesses come and go, but real estate is here to stay. People can establish businesses and run them into the ground, in which case your investment disappears. Historical research shows that 96% of all companies ever formed in the United States have eventually failed with no appreciable gains to their owners over the long term. Real estate, on the other hand, is always there. Even if the REIT is mismanaged, it will be bought by somebody else, and those real estate assets will be used — or they’ll be sold, in which case you’ll get your money back from the sale of that real estate. Just like investing in real estate is safer than the stock market in general, so is the case with REITs.
2. Their cash flow is contractually guaranteed. REITs generally are the ones involved in renting any business storefront, apartments, houses or industrial space. That means the income from those rentals is governed by leases. When there is a downturn, it means REITs continue to receive their business income regardless of what’s happening in the economy. That’s very much unlike other companies. For example, in 2008-09, the average rental income from REITs only dropped 2%. Compare that to the kind of 20%, 30%, 40%, even 50% drops in income for corporate investments during that same crisis.
3. REITs are less volatile. On average, REITs only rise or fall about one-third as much as the stock market on any given trading day, week, month or year, which makes them more attractive, particularly if you tend to worry about stock price movements.
4. REITs rely primarily on dividends. Stocks rely on growth. Now, of course, there are dividend stocks, but REITs are mainly a dividend play. I’m going to show you they can generate extremely good stock price valuations as well, but primarily we’re interested in them for dividends.
5. REITs are safer. Right now, the stock market is trading at about 22 times average earnings, which is a very high level. Historically, it’s the highest since before the Great Depression of the 1930s. REITs trade about 18 times their funds from operations — the term we use to describe earnings in the REIT sector — and at a slight discount to net asset value. It means the average valuation for REITs is less than that for the average stock compared to their cash flow. It also means that the valuation of all REITs is slightly less than the valuation of the real estate that they hold, which is excellent. It means if a REIT were to be sold for any reason or wound down, the value of the real estate owned by that REIT could be more than the value of your shareholdings, and you’d get that money back.
6. Here’s the big thing right now: REITs benefit from low interest rates in two ways. First, they benefit in the sense that as bond investors shift to REITs, it’s pushing up the prices of their stock. Part of what I’m recommending to you is you move some of your fixed-income portfolio into REITs. Many people are doing that, and it’s helping them to appreciate in value. That’s because of low interest rates.
What does falling interest rates this mean for REITs?
All REITs are exposed to interest rates due to their borrowing of money through various mechanisms. However, it is the mREITs that make a profit between the borrowing rates and the lending rates. They make their profits on the spread by being highly levered using debt. To deal with an inverted yield curve, the Fed may continue to decrease the short-term rates to the point of moving below zero rates.
The first thing to remember is that lower interest rate are great for agency mREITs. mREITs want lower rates- the lower the better. Why? Borrowing costs.
If we look at the yield curve, we can see that it has become slightly inverted. So even if we are headed for negative interest rates, it is reasonable to expect that shorter maturities will continue to usually be lower rates than longer-term maturities.
So in the case of mREITs, you would have them borrowing money at rates based on the short-end of the curve, and buying debt that was lent based on the long-end of the curve.
If rates were negative, the mREIT could be borrowing at zero or even getting paid to borrow, while receiving a positive interest rate. Additionally, you would have substantial money being made on the legacy mortgages- while many would refinance, not every homeowner can or will refinance. They would be earning 3%+ on one hand while getting paid to borrow the funds they use to hold it. Over time, those loans would be paid off, but only after years of outsized returns. Lower rates means the current MBS they hold become more valuable.
So How Do You Profit?
Since most do not have the capital to create a REIT or start a mezzanine loan company, there are numerous opportunities to create passive income in this sector. REITs provide greater diversification, potentially higher total returns and/or lower overall risk. In short, their ability to generate dividend income along with capital appreciation makes them an excellent counterbalance to stocks, bonds, and cash.
As an owner of real estate property, I look forward to my monthly rent for income. If you buy these mREITs you can generate sizable passive income streams. It is all about the income produced each month. While the price may be volatile, you do not sell your home when a recession hits – do you? Approach these investments as long-term plays.
Here are some monthly income plays to consider:
Dynex Capital (DX) – $15 per share with 12% dividend yield paid monthly – improving prospects as the challenges to their hedge against interest rates is improving. There should be considerable price appreciation in the future.
It invests in agency and non-agency MBS consisting of residential MBS, commercial MBS (CMBS), and CMBS interest-only securities. Agency MBS have a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity, such as Fannie Mae and Freddie Mac.
AGNC Investment Corp (AGNC) - Dividend yield of 11.2% is a REIT, primarily focused on the development of a mortgage portfolio. The bulk of the mortgages it owns are made by government-sponsored outfits like Fannie Mae and Freddie Mac. It's a lower-risk approach toward driving monthly income, though still an effective one. AGNC presently yields 11.2% thanks to the stock's 10% slide over the last year. That pullback was largely rooted in fears that rising interest rates would crimp AGNC Investment's future cash flows, as higher interest rates are presumed to tend to crimp overall lending activity. That's only partly accurate. Higher rates can do mortgage REITs more good than harm if the underlying reason for rising rates is a strong economy.
These ETNs carry more risk as they are levered to an index. You can place smaller bets on these securities to produce more income and raise the current yield of your portfolio.
Credit Suisse X-Links Monthly Pay 2xLeveraged Mortgage REIT ETN (REML) at $22.00 per share with a outsized 25% dividend yield. It provides a monthly compounded 2x leveraged long exposure to the price return version of the FTSE NAREIT All Mortgage Capped Index. With AUM of $76.5 million, the note trades in lower volume of 35,000 shares. REML has gained 11.8% in the year-to-date timeframe.
ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (MORL) trades at $16.50 with a 16.1% yield. MORL seeks to track twice the monthly performance of the MVIS Global Mortgage REITs Index. It has amassed $420.8 million in its asset base while trading in solid average daily volume of about 300,000 shares. The ETN was up nearly 24.4% so far this year.
ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (MRRL) trades at $12.60 with a 16.1% yield. This note is linked to the monthly compounded 2x leveraged performance of the MVIS US Mortgage REITs Index. It has AUM of $100.4 million and trades in average daily volume of about 132,000 shares.