Sviatlana Barchan/iStock via Getty ImagesWe don’t usually see the mREITs dramatically outperforming the BDC sector. But it sure happened this year.There are at least two factors in play:Short-term rates are falling.Bankruptcies by a few borrowers are making investors skittish about other unrelated loans.We’re going to focus on the recent relative strength in the mortgage REITs this time, as we talked about BDCs last time:12% Dividend Yield, Nice UpsideHigh-Yield Investors Get HammeredWe can use the $100,000 chart to compare the recent performance for some sector-based ETFs:The REIT ForumBecause this chart is built around the values today, it does a much better job of demonstrating how prior investments would’ve done based on any possible date range. Who wants a chart that anchors everything to an arbitrary starting point? In our chart the ending point might be arbitrary, but “today” is usually the most useful arbitrary date you can get. Sorry, I can’t give you two years in the future. However, our charts do a great job of adjusting for the dividends. Because when you’re investing in shares with huge yields, you really need to factor that into the calculations. Huge yields are not free. They come with risks, and they are a major part of the return picture.The Mortgage REIT ETFWe’re using the VanEck Mortgage REIT Income ETF (NYSEARCA:MORT) to represent mortgage REITs and using the VanEck BDC Income ETF (BIZD) and Putnam BDC Income ETF (PBDC) to represent the BDCs. In the chart above, it's clear that MORT outperformed starting from any point in the last 12 months. In some cases, the outperformance was substantial.So what’s going on? Well, first we should have a quick look at the holdings:VanEckThe top two positions are in mortgage REITs focused on agency mortgage-backed securities. Agency mortgage REITs are particularly sensitive to interest rates. However, many people misunderstand the exposure.The MisperceptionMany people think that mortgage REITs, and especially agency mortgage REITs, simply benefit from lower interest rates. However, that isn't the case. If mortgage rates decline dramatically, that has a negative impact on mortgage REITs because it leads to a surge in prepayments on mortgages that had higher coupon rates. That would be bad for the mortgage REITs.Here’s an example using the holdings from AGNC’s portfolio:AGNCThere are three major ways someone may prepay their mortgage:They pay it off by refinancing.They pay it off because they're selling the house.They pay it off by paying extra principal along with their payment.What kind of prepayment surges when rates fall? It’s the first option. People with higher-rate mortgages refinance into lower-rate mortgages.My condolences to everyone who didn’t have a chance to buy a home in the last 17 years. There were some pretty nice opportunities. I could pay extra on my mortgage, but I won’t. It’s locked in at 2.125%. Why would I pay extra for that? I just pick up short-term Treasuries (okay, a Treasury Bill ETF). I still get the flexibility of having cash, and I get more than enough interest to offset the cost of the mortgage.What if Rates Rise?Currently, all the focus is on rates falling. But we should at least address the other potential scenario. Mortgage REITs don't want rates to increase significantly because:The value of their MBS holdings would decline.The cost of financing would increase.The prepayments on their MBS would decline too much, which would make it take longer to get their money back to reinvest.What Mortgage REITs Can DoIf rates reverse and climb higher instead, then mortgage REITs would gradually shift into higher-yielding mortgages, but it takes time. They could sell off lower-yielding mortgages in that scenario, but they would be forced to accept much lower prices. Consequently, they typically prefer to be a little less active in managing the portfolio. In short, the mortgage REIT would prefer that interest rates not increase or decrease dramatically.What About Fed Funds Rates?Mortgage REITs do stand to benefit from a reduction in the Fed Funds Rate. They often hedge less than the entirety of their borrowing costs, and when that happens, it allows them to benefit from lower short-term rates. Unfortunately, many investors seem to think that mortgage REITs will only hedge a very small portion of their exposure to funding costs. That would be horribly inaccurate. They typically hedge the substantial majority, at least for the short to medium term. There have been times when we've seen them hedge more than 100%.The ideal scenario for mortgage REITs involves mortgage rates remaining relatively stable with a very gradual decline in the Fed Funds Rate.When we look at the largest mortgage REITs, which are also the top two holdings in MORT, we see fairly high valuations. Their price-to-book value using our recent estimates is about 1.08x and 1.23x. That’s lower than the ratio in the chart. By our estimate, book values for these mortgage REITs have probably increased by about 4% to 5% between 6/30/2025 and last Friday. Yes, we run our estimates pretty frequently. The changes in book value we are projecting throughout the sector are materially different, though. While Annaly (NLY) and AGNC (AGNC) were pretty similar to each other, some of the mortgage REITs are likely to report declines in book value per share for Q3 2025.Do I Like Mortgage REITs Here?There are some opportunities. A few are expensive, but there are a handful that are getting pretty cheap. For common shares, I’ve been more active in the BDCs than in the mortgage REITs lately. Just taking advantage of that big slide in BDC prices. However, I might pick up some of the mortgage REIT common shares as well. It’s not a bad time, but I would want to pick those entries carefully.I'm typically more interested in finding opportunities to trade in preferred shares and baby bonds. We still get an attractive yield, but the prices are much steadier. That’s still my general theme. I’ll keep looking for opportunities to allocate to the preferred shares and baby bonds, but with the recent weakness, I'm starting to take on a bit more common share exposure again.I'll disclose an extra trade here. While AGNC and NLY are the biggest agency mortgage REITs, we've often been more interested in Dynex (DX). Scott Kennedy initiated a position in DX in late September at $11.95 and sold it just under a week ago at $13.05. Simple trading around price-to-book ratios.Analysis StrategyWe’re constantly working on providing new updated estimates for BV (book value) and NAV (net asset value) in The REIT Forum. However, many investors fail to even compare the trailing values. In this series, we calculate the price-to-trailing BV or NAV for many mortgage REITs and BDCs as well as providing several metrics on baby bonds and preferred shares. Charts for those things are available near the end of the article.We emphasize price-to-BV and price-to-NAV because those metrics provide insight into valuations.All the StocksThe charts compare the following companies and their preferred shares or baby bonds:BDCs: (CSWC), (BXSL), (TSLX), (OCSL), (GAIN), (TPVG), (FSK), (MAIN), (ARCC), (GBDC), (OBDC), (SLRC)Commercial mREITs: (GPMT), (FBRT), (BXMT)Residential Hybrid mREITs: (MITT), (CIM), (RC), (MFA), (EFC), (ADAM)Residential Agency mREITs: (NLY), (AGNC), (CHMI), (DX), (TWO), (ARR), (ORC)Residential Originator and Servicer mREITs: (RITM), (PMT)Note: NYMT recently changed their ticker to ADAM. The new ticker is included in our charts. The baby bonds and preferred shares also changed tickers, with NYMT being replaced by ADAM within each ticker. For instance, NYMTZ became ADAMZ.Embedded ChartsMortgage REITs and BDCs:The REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumPreferred shares and baby bonds:The REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumThe REIT ForumThanks for reading, and I hope you enjoyed the charts.Some terminology:FTF = Fixed-to-floating. Share is currently fixed but will begin floating based on SOFR. We may reference LIBOR, but that's assumed to be SOFR + 0.26161%.FTR = Fixed-to-reset. Share is currently fixed. It will eventually begin resetting every 5 years based on the 5-year Treasury rate.FTL = Fixed-to-lawsuit. The company decided that their FTF shares could be "fixed-to-fixed" despite clearly violating the original intent of the contract.Floating = A share that was FTF but is now floating. The dividend rate is updated every three months.Thank YouEditor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.