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Income-hungry investors have long flocked to mortgage-backed real estate investment trusts — and why not? Many of them pay a handsome, double-digit dividend. But such vehicles haven't done so well lately.
That's because when interest rates rise and yields balloon, their valuations tend to suffer, which is what happened after it became clear in 2021 that the U.S. Federal Reserve would embark on an aggressive, multiyear tightening campaign. Many REITs experienced declines of more than 50% after that point.
Yet, unlike the commercial-focused portion of this market — which continues to face steep headwinds in the wake of pandemic-induced changes to the American workplace — the outlook for residential mortgage REITs may soon perk up. That's due to a slew of economic data pointing toward a so-called soft landing, a slowdown in economic growth that avoids a recession, becoming more plausible.
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Inflation is at its lowest level in more than two years. The labor market has settled into a Goldilocks zone — that is, one that is not too hot or cold, but just right — of slowing but still has solid job gains, with the unemployment rate at historic lows. Meanwhile, second-quarter gross domestic product figures blew past estimates and consumer sentiment last month notched its highest reading since October 2021.
None of this is to say that a soft landing is a sure thing — far from it. Notably, inflation data will start to go against harder-to-beat annual comparisons beginning with the U.S. Department of Labor's upcoming consumer price index report due out this week.
Also, keep in mind that it takes time for rate hikes to make their way through the system. The labor market has held up until now, but who is to say that cracks won't emerge soon?
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Still, were the Fed able to tame inflation without sparking a recession, interest rates would presumably begin to retreat in 2024. Importantly, that scenario would also help the residential mortgage REIT industry avoid what most at the beginning of the year thought was a certainty: widespread defaults.
Together, that sequence of events would initiate about an 18-month cycle where the book values of mortgage REIT companies spike, juicing their stock prices. What's more, by getting in during the embryonic stages of this trade, investors can secure an opportunity to collect outsize income payments, just as other yield-producing investments may face challenges due to the prospect of declining rates.
These two REITs are worth a second look
To clarify, mortgage REITs don't own the mortgages themselves. Instead, they invest in mortgage-backed securities, collect the interest and then return those income streams to investors. Two REITs to consider include AGNC Investment Corp (NASDAQ: AGNC) and Annaly Capital Management Inc. (NYSE: NLY).
Beyond the favorable dynamics described above, the two companies share several commonalities that make them potentially attractive:
- Each currently trades at a discount relative to their current book values.
- Both fell off a cliff in 2021, just as the Fed began to put an end to years of easy-money policies, giving them plenty of room to run.
- Each began to stabilize earlier this summer after the Fed opted against increasing rates in June and speculation began to ramp up that the tightening cycle could end soon.
- Both pay an enormous dividend. Annaly's is 13.15%, while AGNC's is 14.5%.
Investing has many hard and fast rules. One of the most important rules may be that there's a time and a place for everything.
Over the past two years, residential mortgage REITs, despite the dividends, were not a great place to be. But if it becomes more apparent that the Fed can thread the needle and engineer a soft landing, it will be the right time to add mortgage REITs to your portfolio.
— By Andrew Graham, founder and managing partner of Jackson Square Capital
