Do mREITs Have Much of a Future?

Mortgage REITs like Annaly Capital Management (NLY -0.32%) and American Capital Agency are sitting on tens of billions of dollars of mortgage-backed securities and offer dividend yields of more than 12%. But there's a catch.

Due to a perfect storm of factors, mREITs have seen fantastic growth in the last few decades. In this video segment, Fool contributor John Maxfield and Motley Fool analyst Gaby Lapera talk about what previously made this asset class so successful, and why this will probably fade in the coming years.

A full transcript follows the video.

John Maxfield: We've had a number of companies that really focused in mortgage REITs, as opposed to being a real estate investment trust that focuses in mortgage REITs as just one component, and other types of real estate. For the pure mortgage REITs that trade that investment, it does not look to be very optimistic going forward, and there are two reasons for that.

The first: If you go back to the early 1980s, when we had rapid inflation, the Federal Reserve brought interest rates way, way up to slow down that inflation. So they brought them up into the 18% to 20% range, even for really short-term rates. Ever since then, interest rates have been going down. One of the consequences of falling interest rates is that on the other side of that, the value of fixed-income investments -- which mortgage-backed securities are -- the value of those increases as interest rates go down. So, you have, let's say, Annaly Capital Management or American Capital Agency, you have these companies that are sitting on tens of billions of dollars of mortgage-backed securities, i.e. fixed-income securities, as these interest rates have been coming down. So, those values have just consistently been going up over the years.

Well, interest rates are now plateauing around the 0% rate. So you can't look at a mortgage REIT's past and look into the future and think: "That's what the business will look like in the future," because we just aren't going to see the short-term interest rates go up 20% any time soon. It's hard to envision a scenario under which that would be the case. So, you're going to have that benefit coming away from the mortgage REIT.

The other benefit that you have coming away from the mortgage REIT is, where they really, really made a ton of money over the past couple decades -- and they've done well over the past couple decades, but where they really killed it was during the financial crisis when the Federal Reserve dropped interest rates to near 0% relatively quickly, but the longer-term interest rates took longer to adjust downwards. So, that spread was really wide for a time period. And that's why a company like Annaly Capital Management was so popular and did so well during the financial crisis.

Well, now, again, you have interest rates -- both long and short-term -- compressed right about 0%. So you're just not gonna have the size of the spread. It was literally a once-in-multiple-generations type of thing that made mortgage REITs so profitable over the past couple decades. That, in my opinion, is now gone.

Gaby Lapera: Absolutely. I don't know if listeners out there are wondering how the long-term interest rates are set. Those follow the short-term interest rates; it just takes them longer to adjust because they are, obviously, long-term. So, say, you bought a house pre-financial crisis. You probably had a mortgage with a pretty high rate. That's why a lot of people ended up having to default during the financial crisis.

Now, that has evened out. You can buy a house with significantly lower interest rates on your loans now than you could before.

Maxfield: Yeah. Anybody who's thinking about buying a house, keep this in perspective: Over the last 30 years, the average interest rate on a conventional 30-year mortgage has been something like 8.5%. I don't know exactly what it is right now, but it's something like 3.8%.

Lapera: Yeah, it's super low.

Maxfield: You're looking at historically low interest rates. And then, when you factor in that eventually, you'll have some inflation come back into the equation, so that'll work against that. Let's say we get 2% inflation, and you're paying 3.8% on your mortgage. You're basically paying 1.8% to borrow money. It's just ridiculously cheap right now.

Lapera: Yeah. We should probably talk a little about what mREITs will do in the future. The one that comes to mind is Annaly Capital. They were kind of the first, and still the biggest mREIT out there. But what you're saying that they're doing, in order to cushion themselves for what they know will probably be a lean season for them, is they're starting to move over into commercial real estate.

Maxfield: Right. So, this is the dominant player in the industry, that a couple years ago, has started to diversify away from that pure mortgage REIT business model that did so well for it for so long. If that shouldn't be a sign for investors, then I don't know what is.

Lapera: Yeah. It's kind of how, in the tech industry, when Apple does something, everyone kind of looks to it and says, "You know, maybe we should start thinking about doing that, too."

Maxfield: Yeah. And let me be clear: there are a lot of people who go around and think that Annaly Capital's management is so brilliant because they've done so well over the decades. I have a tendency to think that they were just in the right place at the right time. It was more luck than anything else, is what's behind their success. That being said, they are the industry leader. So, if you want to divine the future of the industry and the trends we're going to see going forward, Annaly is certainly at the cutting edge.

Lapera: Absolutely. That's pretty much all the time we have. Before we wrap up, I want to let everyone know that as part of dividend week, we've put up a free web page that has a selection of dividend stocks that the contributors of Industry Focus are interested in. It is at dividends.fool.com, so go take a look. Again, that's dividends.fool.com. I was told to really enunciate the word dividends, with an S, so I hope y'all got that.