Mortgage REITs can be attractive to income investors, with many sporting double-digit yields, but it's important to know what you're getting into before adding one to your portfolio. In this Industry Focus: Financials episode, contributor Matt Frankel, CFP, discusses the basics of this unique type of company. Plus, host Jason Moser gives his take on Docusign's (DOCU 1.03%) latest earnings report, and the pair answer some listener emails. You'll hear all this and more on this week's episode!

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This video was recorded on June 7, 2019.

Jason Moser: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market each day. It's Monday, June 10. I'm your host, Jason Moser. On today's show, we're going to dig into the wide world of REITs, real estate investment trusts. We're going to take a look at DocuSign's latest quarter. We have a couple of listener emails to get to. And as always, we've got ones to watch for you.

Joining me in the studio today thanks to the magic of technology, as always, it's Certified Financial Planner Matt Frankel. Matt, How's everything?

Matt Frankel: Oh, just great. You get me all day today. There's not an interview or anything. It's just me.

Moser: It's just you, baby. The Matt days.

Frankel: And you. You're here, too.

Moser: Well, yeah, but I'm just the host, man. We're going to shine the light on you, Matt. We had Fool Fest this past week, and that was a lot of a lot of talking and spotlighting and stuff. But I didn't see you there, Matt. And you know what? Matty Argersinger was there, busting into all this great stuff about Millionacres, our new real estate product, and answering a lot of questions, but I didn't see you. I know you're working on that product. Why were you not there?

Frankel: I've actually never been to a Fool Fest. I actually didn't know they existed until two years ago.

Moser: I feel like it's borderline criminal, man.

Frankel: Well, we have a writers conference every year. That's what they make a big deal out of for us. I've only been involved in the premium side of the business for the past couple years. They invite me, but they always invite me, like, two weeks before. With little kids, that really doesn't work.

Moser: Requires a little bit more planning.

Frankel: How much notice do you need to go anywhere?

Moser: Me? Man, I try to get stuff laid out at the beginning of the year.

Frankel: Right, and your kids aren't even that little.

Moser: Yeah, almost 13 and 14. Well, you'll get there eventually. I'll remember that next year. I'll make sure to give you a heads up here well before it happens. We'll get you up here for it.

Frankel: Please do, I'll be there.

Moser: Okay, cool. Well, let's jump in today with our first topic. We wanted to dig into real estate investment trusts, or what some investors may know as REITs. Given that this is the Financials show, certainly our listeners always have questions about REITs. It's a really interesting investment opportunity out there. It's not the most exciting topic in the world. I guess maybe tech is a little bit more of a sexy headline than mortgage rates. But REITs can be really rewarding, and they have been here recently, haven't they?

Frankel: They have. REITs tend to react really well when interest rates are falling. One of the big questions I get -- the most exciting REITs are known as mortgage REITs, so that's what I wanted to go into more today. Those are the ones that have 10%, 12% or more dividend yields. That's enough for especially casual investors to stop and say, "Wait, why would I invest in realty income with a 4% yield when I can get 10% to 12% from these?" So, there are some really high-paying REITs that a lot of income investors really flock to. REITs in general tend to respond well to lower interest rates. It was the only sector that was up in May. It's been a really good time with interest rates falling.

Moser: Okay, so you're talking about mortgage rates. You said that's one of the more attractive areas there. You have mortgage REITs, equity REITs. Tell our listeners a little bit about the similarities and the differences between those two.

Frankel: Equity REITs are what you normally think of. Those are the ones that own properties. Mortgage REITs, I don't necessarily think they're the best deal right now, but they're perhaps the most misunderstood kind. They're so different than equity or property owning REITs that they're actually in a different sector of the market. Equity REITs are obviously in the real estate sector, and mortgage REITs are in the financial sector, just because they're completely different investments. Whereas equity REITs own properties, mortgage REITs own mortgages and mortgage backed securities. But that's not the whole story. They're really very highly leveraged, meaning that -- let me just back up for a sec. Think about it this way. What's your mortgage interest rate, ballpark? Do you know off the top of your head, Jason?

Moser: Yeah, I believe it's 4%.

Frankel: Okay, so let's say one of these mortgage REITs buys the rights to your mortgage, which is paying them 4%. They borrow money at short-term rates -- say 1% or 2% -- to buy that mortgage. They're not just going to pocket 4% and be done with it. No investor would be happy with that. So they're going to borrow money at, say, 2% to buy that. The 2% spread between your 4% and the 2% that they're paying is their profit margin. To supercharge their returns, they'll do that five or six times over so they're making that 2% spread six times on every dollar they have. So they're making 10% or 12% of their investment as a spread, which is how they can afford to pay so much.

Moser: I think the technical term for that is making money hand over fist.

Frankel: [laughs] Right. It's very high leverage. And with leverage comes some risks. I mentioned that REITs generally tend to do well when interest rates are falling. But mortgage REITs really tend to get crushed when interest rates are rising. We just gave that example of your 4% interest rate, and a company, say, getting a short-term loan at, say, 2%, to buy that. Now, if short-term rates spiked by, say, just 1%, and now they're paying 3% to buy your mortgage, their profit margin's been effectively cut in half from that 2% gap to a 1% gap. If short-term rates rise 2% or 3%, their profit margin can go away entirely, or even go negative in some cases.

Now, that's a simplified explanation. These companies have ways of hedging against this. But, it's s not that long of a show. They tend to do really poorly in rising rate environments. Mortgage REITs also tend to do poorly when interest rates are falling quickly. Market rates for mortgages, you're paying 4%, which is pretty low. But let's say somebody's paying 7% on their mortgage, and now the average mortgage rate is only 4%. What's that person going to do?

Moser: Refinance.

Frankel: They're going to refinance. So, you have this prepayment risk when rates are falling. Even if a mortgage REIT ends up buying a ton of mortgages that are paying 5% or 6%, in an environment like we have now, you're going to see a lot of those mortgages be paid off early because people are refinancing and then they don't get any interest rates. So, it's a common misconception that mortgage REITs d well, when interest rates are falling. But really, mortgage REITs do the best when interest rates are steady.

Moser: Okay, that makes sense. I kind of feeling maybe we're generally speaking in a land here where mortgage rates are going to stay fairly steady. I mean, whether they bump them up or down a quarter point, I don't know that really matters all that much.

We don't want to get email from our listeners saying, "Hey, you led us here to the promised land and didn't give us any names." Are there any REITs out there, any investment opportunities out there, that you like particularly, that you think our listeners should take a look at?

Frankel: I've owned Annaly Capital (NLY 0.25%) in the past. That's the biggest mortgage REIT in the market, and in my opinion, the best managed one. Ticker symbol is NLY. It pays right around 10%, I believe. I haven't checked it in the past couple weeks. But that's by far, in my opinion, the best managed. They also can use their scale to their advantage, because they're the oldest and the largest in the market. There's a few others that I like. I know my father invested in PennyMac, which is on my recommendations --

Moser: Hey, they have our mortgage, as a matter of fact.

Frankel: Do they?

Moser: Yep, I make a payment to PennyMac every month.

Frankel: They were formed in the wake of the financial crisis to hold a bunch of distressed mortgages but have since pivoted because distress mortgages obviously aren't as big a part of the market anymore. So they've pivoted, and now hold people's mortgages like Jason.

Moser: My mortgage is definitely not distressed, Matt. I pay my bills on time.

Frankel: Right, that's what I mean. They pivoted to be a normal mortgage REIT over the past few years. It's actually really interesting that you say that because one of their big parts of the business has become mortgage servicing rights. They don't own a lot of the mortgages themselves, but they own the rights to collect the payments.

Moser: It's a lucrative part of the business, for sure. I remember working for a time at Bank of America in the lending department there and became more and more aware of that servicing side. Man, I'll tell you, you can make a lot of money doing that.

Frankel: It's really interesting that PennyMac has the servicing rights to your mortgage. Once the distressed market dried up a little bit, that's really where they pivoted their business. It's cool to see that playing out in the real world.

Moser: Makes sense. All right, that's great stuff there, Matt. I do appreciate you digging into those REITs. Certainly, any of our listeners out there with any further questions on REITs, you can hit us up on Twitter @MFIndustryFocus. Or, hey, even ping Matt there @TMFMathGuy, We'll see what we can do to answer your questions.

Matt, I wanted to take a quick moment here just to review DocuSign's earnings. Earnings came out for DocuSign late last week. Remember, this was my one to watch last week. It was interesting to see how the market reacted to this release, from the after-hours behavior to the close the following day. For a little while, the stock was getting sold off to the tune of about 22%. By the end of close the next day, it was down about 12%. I think everything's leveled off now.

On the surface, it was really a strong quarter. Quarterly revenue was up 37%. Guidance for the full year of 32% growth there on the top line, also strong. This is one of those new businesses that's still getting its feet underneath it, so it's not profitable yet. But it definitely has a model that will be profitable. They have more than 500,000 paying customers now around the world, up from 405,000 in the first quarter of last year. An interesting product they have, their DocuSign Gen, which is essentially for small to medium sized businesses, primarily in the Salesforce (CRM 1.35%) ecosystem. I'm just going to tell you, man, when you're a part of a Salesforce ecosystem, that's a good ecosystem to be a part of. Generally speaking, that is the leader out there in the CRM or customer relationship management space. That they're trusting DocuSign, I think, is a good sign.

I think the main concern there with the quarter focused more on the billings number, which at 27% or so, wasn't bad. I think it was just maybe a little bit lighter than what expectations were. I think the thing with a business like this, though, is you have to be careful. Billings are very sensitive to timing. On a quarter to quarter basis, if billings are a little bit weak or a little bit strong, you can't look too terribly much into that, unless you're seeing a trend develop. We haven't seen that yet with DocuSign. But a lot of times with a company like DocuSign, when they're building out new products and services for their customers, and upselling and adding new customers, you can start to see some timing issues play out on how they're renewing contracts and marking for those buildings as the year goes on.

The bottom line is that DocuSign continues to grow its customer base tremendously. If you look at customers with an average contract value now of greater than $300,000, that grew 51% year over year. They now have 324 customers with average contract values greater than $300,000. To put that in context, in fiscal year 2013, that number was just 30. From 30 to 324, that seems like a trend we should be getting behind. Right, Matt?

Frankel: Definitely. I think of DocuSign as your Green Dot. I had a very similar situation a couple weeks ago, where I gave my one to watch as Green Dot ahead of earnings. And we did watch it, we watched it go straight down after earnings.

Moser: [laughs] But you explained why. I think you had a good explanation.

Frankel: Right. That's my point. On the surface, everything looked good, but there was some weak guidance, which we saw in DocuSign just now. Big thing, investing in new products, which is a big part of DocuSign's earnings report. Both of them are investing more for the future. Current growth is a little slower than the market would like to see. That's why the stock is down. But for long-term investors, this is what you want. This is an ideal situation if you're in it for the long haul.

Moser: Yep, I agree. I think it's one where the total market opportunity out there for a business like this is just so large. They're not going to be the only game in town. They don't have to be. There are other companies out there that do it well also. But DocuSign is obviously doing a lot of good stuff. That's what the numbers are telling us. I'm hanging on to my shares. I could certainly see adding to this position over time, if it seemed like those numbers continued going where it looks like they're going. We'll keep an eye on that billings number. If for some reason we start seeing a trend developing in billings weakness, then we can address that, because that's something that we don't want to just push to the side. But for now, it looked like another strong quarter for what is a strong looking business.

Okay, Matt, we want to jump into a couple of listener emails here really quick before we wrap things up. Jay Otto sent us an email. He said, "I just wanted to let you know that I bought some shares of DocuSign after the dip yesterday. I wasn't waiting for a dip, but it just worked out timing-wise for me perfectly." Then he asks, "I hope you don't mind one other quick question. I know Fool Fest was going on and I was curious -- if you're a Fool member/subscriber, are you able to attend Fool Fest? It seems like a great event, but I feel like I never hear anything about it in advance, and then I see that it's happening. Or, maybe it's targeted at a different audience? I'm not sure. Thanks again for all of your great work."

Listen, Jay, thanks so much. I think you probably made a nice move there with DocuSign. It sounds like that was just good timing on your part. In regard to Fool Fest, Fool Fest for a long time has been targeted to certain number bases. What we ultimately are doing is growing out the people that we are able to bring into Fool Fest because we're finding, clearly, that more people want to come. This year, we were able to move to a bigger facility, and really learn about how to bring in that much of a larger crowd. So I suspect that as time goes on, we will continue to bring in more subscriber bases. Definitely keep an eye out for that. As always, you can drop us a line at [email protected], and we will forward any information we have on any future Fool Fests or other events, because they certainly are a lot of fun.

Another email here from Adele Naji. Adele asks, "What does top and bottom line mean? Top and bottom of what? Keep up the good job." Matt? Top and bottom of what?

Frankel: That's actually a really good question. It's really important to ask if you don't know understand the basics when you're starting to invest. I'm going to answer that one, and I have a couple more of my own. Top and bottom line refers to the top and bottom of a company's income statement. The top line is the revenue number. That's how much a company is selling. Then you have a bunch of things subtracted from it -- say, all your ongoing business expenses, taxes, interest you're paying on debt, things like that. And then you get to the bottom line of the income statement, which is your earnings, or your profit. Generally, that's expressed on a per-share basis. You can see a bottom line as a number in the millions, meaning a company's profit; or you can see an earnings per share, which is also known as the bottom line number. So, top line refers to revenue before anything, just how much a company is selling. Bottom line refers to profitability or earnings.

Another term that I get asked about a lot, not on the show, but just in general, so I wanted to address it, is the difference between these three terms" stock market correction, bear market, and a recession. These terms are often used interchangeably and they have three very different meanings. Being that the market seems to move in and out of correction quite a bit over the past year or so, just starting with correction, because that's the most mild of the three terms. A correction just means a drop of 10% from an index's or a stock's recent high. If a stock or certain index recently topped out at $100, a move down to $90 would be considered a correction. A bear market is a little bit more intense than that. A bear market is defined as a 20% drop from recent highs. If you hear that the S&P just entered a bear market, as it did in at the end of last year, that means it fell 20% from its most recent high. Finally, a recession. You'll hear people misuse recession all the time. If the stock market's doing badly, they'll say, "Hey, we're in a recession." A recession actually has more specific economic meaning. It means two consecutive quarters of GDP decline. Generally, you hear, "GDP grew by 3% last quarter, 2%, whatever." Two consecutive quarters of declining GDP is how you know we're actually in a recession. So, correction, bear market, and recession. All three have very different meanings. The first two have to do with the stock market in particular. The third is more of an economic term that generally means the market's going down, but it doesn't have to. So, those are three terms that are important to know, especially in the context of today's news.

Moser: All right, very good stuff. Let's wrap it up for the week here. What is your one to watch? What stock do you have your eye on this week?

Frankel: See, mine's not actually a stock. I am watching Treasury yields just because of the wide implications on everything we cover here.

Moser: Oh, you finance guy.

Frankel: [laughs] We have a Fed meeting coming up next week, as you know. I won't be on the show next week, so I wanted to mention this. Interest rates have been jumping all over the place lately, mostly in the downward direction because of the threat of tariffs. They popped up six basis points today as I'm talking, which is a pretty big one-day move. So this is definitely worth watching as we're going into a Fed meeting over the next couple of weeks. Banks tend to react positively when interest rates rise. For example, if the Fed doesn't cut rates, you might see an interest rate rise after the meeting. If the Fed does cut rates, you might see interest rates fall a little bit depending on tariffs threats. There's a hundred different variables. If the Fed cuts rates, it could definitely be a positive for the market, meaning lower interest rates. That could be a negative for banks. It'd be very positive for REITs if rates kept falling. A bunch of moving parts there. The big question on everybody's mind is, will the Fed cut rates? The President seems to think they should. A lot of experts seem to think a rate cut is almost priced in at this point. Goldman Sachs actually came out with a research note a few minutes before I started talking here that they don't think the Fed will cut rates this year. That might be an interesting dynamic. They said this year, not just this meeting.

Moser: I was going to say, that seems to be a bit of a contrarian take altogether.

Frankel: Yeah, that's a pretty bold call, especially coming from someone as big as Goldman Sachs, who's generally pretty accurate with things like these. So I'm watching interest rates as we go into the Fed meeting. A great one to watch for bank and real estate investors is the 10 year Treasury. It seems to be a really good indicator on what those stocks are going to do.

Moser: I am going to go with a stock this week. Salesforce is one that's in the news. Salesforce is making an acquisition of a company called Tableau. Ultimately Salesforce is an online solution for customer relationship management. Tableau is a company that's going to help them make more sense of the data that they get, and figure out how it can be best used to help their customers. Ultimately, this really is a play on the digital economy. It's estimated that by 2022, more than 60% of global GDP will be digitized. I think that makes a lot of sense if you look around at how we're spending our money today. I think it's really interesting, the way Salesforce is accomplishing this deal. It's going to be an all-stock deal as opposed to using any cash or debt. The stock price, near all-time highs. I think that's a clever way to go about it when you have to make a big acquisition like this, $15-16 billion. The stock price is high, use all stock, that's essentially a cheaper form of currency. They will be able to protect the balance sheet. I think that given the business that they're adding, it should actually be accretive to Salesforce's financials in fairly short order. So, shareholders shouldn't really feel too diluted, and should still feel happy about owning a leader in the space.

With that said, Matt, I think we'll wrap it up here. Man, appreciate you being here with us this week.

Frankel: Yeah, it was a fun show.

Moser: Absolutely, as always. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. Today's show was produced by Austin Morgan. For Matt Frankel, I'm Jason Moser. Thanks for listening, and we'll see you next week.