Why Is Orchid Island Capital's Dividend So High?

Big dividend yields aren't always what they seem even though they tend to attract a lot of investor attention. Today, yield seekers can collect a fat monthly dividend check from Orchid Island Capital (ORC 3.93%). How fat? Well, the dividend, annualized, equates to a massive 17% yield.

Before you jump in, you need to learn a little bit more about this mortgage real estate investment trust's (REIT) business and history.

A complex business

A traditional REIT owns physical property and leases it out to tenants. That's not a particularly complicated business model. A mortgage REIT (mREIT) like Orchid Island buys mortgage bonds that have been pooled together into securities that trade like bonds. These are often called something like collateralized mortgage obligations, or CMOs. The REIT collects the interest from these securities. The money they make is derived from the spread (or, more simply, the difference) between the interest they earn and their cost of capital. Often, to enhance returns, mREITs use leverage.

Image source: Getty Images.

Admittedly, it can be a complex business. There are a lot of moving parts here. For starters, leverage can enhance returns on the upside, but it can also increase losses when things don't work out as planned. The first line of the REIT's corporate overview is very clear: "Orchid Island Capital, Inc. is a specialty finance company that invests in residential mortgage-backed securities on a leveraged basis." So before even looking at the CMO issue, investors need to recognize the inherent risk of the leverage-based business model.

CMOs trade based on supply and demand. That's true of physical property as well, but buying and selling buildings is relatively infrequent, whereas CMOs can trade every day all day long. That means their prices change a lot faster than the price of a physical building. And when interest rates are on the rise as they are today, bond prices fall so that the yield remains high enough to compete with newly issued bonds. In other words, Orchid Island's CMOs are declining in value given the rising interest rate environment, which can be seen in its book value change over the past year.

Book value per share for a mortgage REIT is, basically, the value of its portfolio. At the end of 2021, Orchid Island's book value was $21.70 per share, adjusted for a 1-for-5 reverse split that took place that year. At the end of March 2023, the estimated book value was $11.56 per share. In a little over a year, the company's book value has declined by over $10 a share, or roughly 47%. Notably, the leverage mREITs take is often backed by their CMO portfolios, so there are even further risks to consider here when thinking about a decline like this.

You should not buy Orchid Island stock without fully understanding the very complicated nature of the mortgage REIT model. But there's another trend that is even more telling and doesn't require much research to understand.

Down, down, down

While Orchid Island has a huge 17% dividend yield, this figure actually represents the comparison of the dividend to the share price. It is telling to start off a discussion of dividend yield by looking at Orchid Island's dividend history. 

Data source: Orchid Island.

That table makes it pretty clear that the dividend has been trending lower since 2014. The only year in which it didn't decrease was 2017, but staying the same for two years running, given the longer-term downtrend, is not a cause for celebration. Still, the really important piece of this story comes when you compare the yield, the dividends paid, and the stock price.

Yield and stock price go in opposite directions, with a falling price leading to a higher yield and vice versa. But Orchid Island's yield has remained fairly high across the entire span that the dividend was falling. The only way that can happen is if the stock price falls along with the dividend, which is exactly what has transpired.

ORC data by YCharts.

So dividend investors lured in by a high yield in this situation would have suffered both a drop in the income they collect and a loss of capital. Not fully understanding what you own would have been a very costly mistake, particularly if you were trying to live off the income your portfolio generated. Orchid Island is working to position itself for a recovery, owning lower-coupon, long-duration CMOs that would be expected to appreciate notably in value if interest rates fall. That's a fine approach, but it highlights that mREITs are more akin to bond funds than landlords that pay reliable dividends over time.

Most income investors should avoid it

There's nothing inherently wrong with an mREIT like Orchid Island Capital if you understand what it does. However, if you are simply attracted by the huge dividend yield, you may end up very sorry you bought this company. The dividend just isn't something you can count on, as history has clearly shown. Most dividend investors will want to avoid it and its mREIT peers.