NEW YORK CITY—Compressing margins are leading mortgage REITs to diversify outside of single-focus investments in order to maintain target dividends, Kroll Bond Rating Agency says in a new report on the sector. An added inducement to mREITs evolving and expanding their business models, says KBRA, is the possibility of rising interest rates.

KBRA cites recent moves by Annaly Capital Management as a case in point illustrating where the sector is headed. The largest residential mREIT, Annaly has diversifed away from its agency-only mortgage business model by hiring a team of commercial real estate investors from the GE Capital Real Estate group.

This represents “a significant change” for Annaly, KBRA says, since its main business has been principally in residential MBS for the last two decades. “In this regard, Annaly's investment guidelines allow the company to invest up to 25% of its equity in 'real estate assets other than agency mortgage-backed securities.' In our view, these assets will be most likely related to commercial real estate, which currently account for approximately 4% of the company's assets.”

The rating agency sees Annaly's strategic move as a template for other traditional mREITs with an exclusive focus on residential MBS, which exposes the portfolios to interest rate risk. “As interest rates move up, the value of mortgage backed securities in the portfolio will go down,” according to KBRA's report. “Therefore, by diversifying into commercial real estate, Annaly, should be able to offset some of the challenges as interest rates begin to rise.”

The history of mREITs dates back to the early years of REITs, period, but their current vogue is a product of the Great Recession. Nineteen new mREITs debuted between 2008 and 2013, with mortgage portfolios and sector market capitalization growing by over 250% and 320%, respectively.

The federal government has given MBS a great deal of financial support since the financial crisis, with the Treasury Deapartment and Federal Reserve buying a total of $1.4 trillion in such securities between 2011 and '13. Couple that with strong investment demand for yield- paying securities, and you have a recipe for mREIT sector's growth.

KBRA cites the “competitive yields” mREITs can provide for institutional and retail investors alike. mREITs provide competitive yields. “The dividend yield of the FTSE NAREIT Mortgage REITs Index was 11.25% as of June 30, 2015, easily outpacing the dividend yield of the S&P 500 of roughly 2%,” according to KBRA.

However, says KBRA's report, “the current environment of margin compression, with high-yielding bonds being replaced with lower-yielding securities while the cost of funding remains unchanged, is forcing residential mREITs to look for alternatives in order to maintain target dividends. KBRA believes residential mREITs are faced with two paths; 1) increasing leverage, or 2) diversification.”

The sector historically has maintained what KBRA consider to be moderate levels of leverage, with debt to equity ratios of 3x to 5x for non-agency portfolios and 6x to 8x for agency portfolios. “While increasing leverage might be an option for a select few companies, most companies will face limitations levering up,” says KBRA.

The traditional repo lenders, investment banks, have taken the necessary steps since the financial crisis to amend repo financing agreements with mREITs. Among other stipulations, these agreements now include leverage covenants limiting mREITs ability to significantly increase leverage. Accordingly, says KBRA, “Given leverage limitations and incentive to reflect the low risk preferences of their investors, the second option, diversification, is becoming far more compelling to traditional residential mREITs.”