Dividend income from mortgage REITs is attractive but risky. Image: TaxCredits.net via Flickr.
Real-estate investment trusts have been a great income-producing investment in recent years, and REITs that invest in mortgages have been especially generous in paying dividends. Yet there's growing debate about whether mortgage REITs are cheaper than ever or poised for further declines. To look at all sides of the issue, we turned to three of The Motley Fool's financial analysts to share their views on the mREIT space.
Jason Hall: I won't beat around the bush: I don't see so-called mREITs as a group doing well over the next half-decade or so.
The reason why is simple: Rising interest rates are almost a foregone conclusion at this point, and this is going to put a squeeze on the rate spread that mREITs make a living on.
mREITS tend to rely heavily on short-term debt for funding but hold long-term assets for income. In other words, a bundle of 30-year mortgages will pay the same interest until the loans are satisfied, while the mREIT that owns the mortgage-backed security will need to constantly renew its short-term loans based on the available rate. As rates increase, the spread gets squeezed.
Worst-case scenario: Some mREITs will hold securities that pay out lower fixed rates than their cost of short-term debt, forcing them to sell those assets. The double whammy is that they will sell those assets at a loss, too, since they will be less valuable than new securities at higher rates.
Frankly, even with many mREITs really beaten down today, it's hard to see a bright future ahead for the industry. Don't get me wrong -- there probably will be some big winners as the best-run companies navigate the pitfalls, but for the average investor, picking the winners may be a serious challenge.
John Maxfield: When I think about mortgage REITs, my initial reaction is that they're in for tough times ahead. However, when I force myself to think about the issue on a deeper level, I can't help but think that there could be value in the sector.
My thought process stems from the fact that the lion's share of a mortgage REIT's holdings consist of mortgage-backed securities. And while there's nothing innately wrong with MBSes, there is one issue that could wreak havoc on mortgage REITs. Namely, MBS values are inversely related to interest rates; as rates rise, MBS values fall, and vice versa.
This is problematic because many people, myself included, expect rates to start moving higher as the economy improves and the Federal Reserve feels confident that it can normalize rates without driving the economy back into recession, as it infamously did in 1937.
My opinion in this regard is based on the fact that the principal short-term interest rate benchmark, the Fed funds rate, has averaged 5.04% over the past 60 years. By contrast, it's a mere 0.13% right now. Thus, not only do interest rates seem poised to rise, but they seem ready to rise by a huge margin.
But here's the problem with that analysis. The only reason the Fed funds rate has averaged 5.04% since 1954 is because the central bank scaled up rates to fight double-digit inflation in the late 1970s and early 1980s. Without that anomaly, the Fed funds rate would have been much lower -- so much lower, in fact, that the currently depressed valuations on mortgage REIT stocks may more than compensate investors for the interest rate risk they assume by holding the stocks.
Another point that's worth keeping in mind is that it isn't entirely unreasonable to think that interest rates could stay low for decades to come. This is what's happened in Japan since its property bubble burst in the early 1990s. If this happens here, then mortgage REITs have much less to be concerned about from the perspective of interest rates than most people think.
Dan Caplinger: Both Jason and John make good points about the pros and cons of mortgage REITs in the current economic environment. Yet you also have to keep in mind that mortgage REITs themselves are quite aware of the risks involved with interest rate fluctuations, and each set of REIT managers approaches the situation differently. As a result, even once interest rates start to move, you could see widely different fundamental performance among different players in the industry.
The key lies in looking at the positions that various mortgage REITs can take to hedge their interest rate exposure. Some companies simply hold their portfolios of mortgage-backed securities without any offsetting positions, accepting interest rate volatility as a fundamental aspect of their business and leaving it to shareholders to judge their own appropriate risk level by buying or selling shares. Others take a more active view toward risk management, supplementing their MBS holdings with investments that actually move in the opposite direction of MBS prices when interest rates move. These active risk managers pay a price for their hedge positions when interest rates don't end up moving against them, but as an investor, you might be willing to give up that additional potential return in exchange for smaller losses or even gains if interest rate conditions turn. Investors really need to look at mortgage REITs on a case-by-case basis to know whether they're likely to rise or fall in the future.
