Surprise! Mortgage REITs Are Kicking Butt Since the Fed Started Raising Rates

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In December 2015, the Federal Reserve announced a shift that the U.S. economy and stock market hadn't seen since 2006. For the first time in practically a decade, the Fed raised its federal funds target rate by a quarter of a point. The move wound up pushing its target rate from an all-time record low of 0%-0.25%, where it sat for seven full years, to 0.25%-0.5%. Since then, the Fed has enacted three additional quarter-point hikes.

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Monetary tightening usually comes with a push-pull for the U.S. economy and stocks. Higher interest rates often provide a cooling mechanism for inflation and growth, since it becomes costlier to borrow money. This reduces the incentive for businesses to borrow in order to expand, reinvest, or perhaps acquire new businesses. Yet, at the same time, monetary tightening is needed because the economy is growing at a steady pace. There are two sides to this coin.

Few on Wall Street saw this coming

However, for the mortgage-based real estate investment trust (mREIT) industry, higher rates are supposed to mean one thing: bad news. Mortgage REITs make money on the difference between the rate at which they borrow and the rate at which they lend (mREITs typically buy mortgage-backed securities that pay a yield -- this is the aforementioned "lend" rate). This borrowing is often done utilizing short-term rates, and the lending is done at long-term rates. Thus, when interest rates rise, the short-term rate is most directly impacted, narrowing the all-important net interest margin that fuels net operating profits for mREITs.

But here's the kicker: We've witnessed the exact opposite impact since the Fed began raising rates. Since the Dec. 16, 2015, rate hike, shares of Annaly Capital Management (NYSE: NLY) and AGNC Investment Corp. (NASDAQ: AGNC) are up a respective 61% and 53%, inclusive of dividends.

Why the surge in the share prices of mREITs? It probably boils down to two factors.

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The first is that Wall Street appears to have vastly overestimated how quickly the Fed would raise rates. Despite raising rates three times over the trailing 12 months, the Fed has passed on opportunities to increase the pace at which it's lifting its federal funds target rate. Chairperson Janet Yellen continues to walk on eggshells, as inflation data has been below the long-term target rate of 2%, and U.S. GDP growth has vacillated between low and moderate growth rates for some time. If rates don't rise rapidly, it should give mREITs a chance to adjust their mortgage-backed security portfolios and leverage to more optimally benefit when rates do rise.

Second, Wall Street may have underestimated the leadership at Annaly Capital Management and AGNC Investment Corp., which have both seen this rodeo play out before. Annaly has been in the mREIT space for two decades, while AGNC, which was founded in 2008, is headed by CEO and CIO Gary Kain, who has most than two decades of knowledge in the mortgage industry. 

Mortgage-REIT dividends make these stocks potentially attractive buys

What makes mREITs so attractive is their dividends. In exchange for returning 90% or more of their profits to shareholders in the form of a dividend, REITs aren't taxed at the normal corporate rate. For years, this has allowed investors to capture a 10% to 20% annual yield (yes, annual!) on mREITs like Annaly and AGNC. Wall Street's worries over higher rates led to the expectation of a sizable reduction in net interest margin and dividends for both companies, but we just haven't seen that materialize to the extent that the Street expected. Both Annaly and AGNC are still yielding very close to 10%. Assuming their stock prices and dividends stayed pat, you could double your money in seven years on that payout alone!

While additional interest rate hikes are expected (possibly this December, and a few projected in 2018), which could weigh on the net interest margin of mREITs, those that specifically target agency-only mortgage-backed securities (MBS) should be in the best shape. Annaly and AGNC deal predominantly with agency-only MBSs, meaning their assets are guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae in the event of a default. This doesn't make agency-only mREITs impervious to an economic downturn, but it puts them in considerably better shape than their more aggressive peers that deal with non-agency assets.

For instance, Annaly's second-quarter results showed it had $88.4 billion in agency assets on its books, compared to $2.6 billion in residential credit, $2 billion in commercial real estate, and $0.8 billion in middle-market lending. Meanwhile, AGNC's balance sheet at the end of the second quarter showed $63.8 billion in assets, including $46 billion in agency MBSs and just $0.6 billion non-agency securities. Eventually, the economy will contract or enter a recession again, pushing loan default rates higher. When that does happen, these agency-only portfolios are going to be in much better shape than their peers.

If you have a long-term mindset, these overlooked high-yield mREIT names may be worth adding to your portfolio.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.