Hybrid REITs combine both strategies in an attempt to diversify real estate investment alternatives. When interest rates are high, Equity REITs will suffer because their capital will be more expensive. Consider the capital asset pricing model. As rf increases the expected return of equity or cost of equity must also increase. Additionally, many equity REITs use the debt markets to fund some portion of their investments. Even though REITs do not get the tax benefits of interest expense deductions, debt capital may still be less expensive than equity capital. Finally, the payout requirements placed on REITs force REITs to constantly raise debt and equity for future investments.
In contrast, as long-term interest rates rise, Mortgage REITs experience better spreads. This enables them to borrow at low short-term rates and lend at the higher long-term rates. Additionally, as loan prepayments come in or as loans expire, the money can be reissued at a higher rate.
The opposite of both stories holds true as well. As interest rates fall, Equity REITs are able to access capital cheaper. This allows them to take on more projects and grow rapidly. Putting more capital to work (doing accretive projects) increases their capacity to do deals and drives up overall real estate prices. This increases the value of their existing portfolio as well.
Similarly, as interest rates fall mortgage holders are more likely to prepay their loans in order to refinance to a lower rate. Not only will mortgage companies be saddled with lower margins, but they will also suffer from the loss of past high interest rate borrowers.
Some of this is muted by the fact that Mortgage REITs need a wide interest rate spread. Even when rates are high or rising, if there is a low or negative spread between short-term and long-term rates, Mortgage REITs may not have any opportunities to make money.
The Interest Rate Exposure Problem
Real Estate Investment Trusts were originally intended to allow small investors the opportunity to invest in real estate. Since that time they have evolved into strong diversifiers for large portfolios. As such Mortgage REITs have increasingly been looked at as a hedge for interest rates, while Equity REITs have been relied on for true real estate exposure.
A study by Youguo Liang and James Webb, “Pricing Interest Rate Risk for Mortgage REITs,” bears this out. Their paper proved that interest rate uncertainty accounts for most of the risk in Mortgage REITs. Additionally, they showed that Mortgage REITs provide a good hedge against anticipated changes in interest rates. What is also important to note here is that if interest rates account for most of the risk in Mortgage REITs, the interest in Mortgage REITs for pure real estate exposure might be inappropriate.
Equity REITs also show some exposure to interest rates, but tend to track the stock market index better. Another study showed that the broad stock market index track REIT returns better than short-term/long- term interest rate spreads. This makes Equity REITs a good play for exposure to the real estate market. This study also found that Equity REITs were influenced by interest rates and spreads, however.
Combining Mortgage REITs and Equity REITs should give investors exposure to both interest rates and the greater real estate market. The problem with this combination is that both vehicles have exposure to interest rates. This exposure becomes magnified with the combination. Liang and Webb showed that interest rate risk could not be diversified away in Mortgage REITs, so this combination would actually be worse for investors because they get more risk and no positive diversification benefits.