It looks like the picture is more complex than simply rising rates = bad for mREITs.
Their margins and thus their dividends are based on the interest rate spread. We can use the treasury yield curve as a proxy here. Just for sake of argument, let's say mREIT borrowing rates and mortgage rates are 0.5% above treasury rates. Suppose the mREITs use repurchase agreements to borrow at an average 6 months duration and buy at an average 20 years duration (made up numbers). Today that spread would be (1.69 + 0.5) - (0.08 + 0.5) = 1.61%.
https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/TextView.aspx?data=yieldIf we go back in time to, say, Feb 1, 2017, that spread was 2.15%. Thus, not only did the 20y rate decrease by 1.11% in those 4 years, but the yield curve also compressed during that time as the shorter-durations met resistance near the 0% boundary and the longer durations kept falling. This half-percent change in the spread is translated to a much larger earnings impact when you factor in 6-8x leverage. One could make a case that the yield curve is not likely to compress further, and that's a bullish sign for mREITs.
Yet, as mREIT operating margins fell during the past 4 years, the stocks themselves mostly treaded water. Margin losses were mostly offset by appreciation of the mortgage portfolio as interest rates fell (partially offset by the loss of income due to prepayments).
If rates went back up to 2017 levels, we might expect depreciation of the mortgage portfolio to be offset by improved margins and a reduction in prepayments. However, mREITs would still be stuck with a portfolio of fixed rate mortgages and rising borrowing costs.
If borrowing rates rose beyond the interest rates in the mortgage portfolio, earnings would go below zero and one might think the mREITs would be pressured to liquidate their mortgages at highly discounted values rather than continue losing money. In reality, they hedge interest rate risks to the portfolio using swaps, swap options, treasury futures, and other instruments. Here's a good explanation:
https://seekingalpha.com/article/4112107-mortgage-reits-how-hedge-interest-rate-riskSo maybe mREITs are a good choice right now IF one is willing to assume the following:
1) They have adequately hedged interest rate risk at a reasonable cost, and
2) The yield curve is more likely to expand than contract if rates rise, and
3) We will not be seeing a sharp rise in foreclosures.
I'm satisfied with assumptions #2 and #3, but I wonder if slim margins have persuaded some mREITs to reduce their hedges and bear more interest rate risk. If I can resolve that question, residential mREITs would seem like a good way to escape the risk of high valuations in the stock indexes.
