How These 2 Monster Dividend Stocks Work

Mortgage REITs can be downright confusing. Here's your simple guide to understanding how these companies work.

Apr 16, 2014 at 10:22AM

Money

Source: Flickr / Images of Money.

"If it's not returning cash to me, it's a speculation."

-- Kevin O'Leary, Shark Tank

There's nothing greater than a company that pays you cold hard cash. A strong dividend is the way into this investor's heart, and if you're like me, you'll love mortgage real estate investment trusts, or mREITs.

REITs were created in 1960 to give the everyday investor an opportunity to invest in real estate. To qualify as a REIT, 75% of the company's assets must consist of real estate investments, and the company must distribute 90% of its earnings to shareholders. By doing so, REITs are generally not subject to federal or state corporate taxes. 

Because of this, many of today's mREITs like Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) have dividend yields -- or annual dividends per share divided by stock price -- north of 10%. This obliterates nearly every other industry.

How do they work?
After making mortgage loans, banks have the opportunity to sell the rights on the loan to an entity. These entities gather tons of mortgages, package them into pools called securities, and sell them into the open market.

These securities, now called mortgage-backed securities, or MBSes, are purchased by insurance companies, banks, mREITs, and others. The entity will take a fee, and the rest of the proceeds go back to the lender.

After purchasing an MBS, the payments homeowners make on their mortgage "pass through" into the pocket of the security holder. 

Who are these entities?
Loans are secured by two different groups: agencies and non-agencies. Annaly Capital and American Capital Agency are considered agency mREITs because the vast majority of their securities are loans packaged by Fannie Mae and Freddie Mac.

There are two big differences between agency and non-agency securities. First is the type of loans they package. Fannie Mae and Freddie Mac will only take loans that fall within a certain price range, and from borrowers with stronger credit ratings. Non-agencies package loans for everything else. This can be low credit quality loans, jumbo or large loans, or commercial loans, among others.

The second big difference is that loans secured by agencies are guaranteed in case of default. If the borrower is unable to pay, Annaly Capital and American Capital Agency will still be make whole. Because these loans don't have default risk, they're considered safer. Non-agencies don't guarantee their loans, however, these securities have a much higher yield. 

At the end of 2013, Annaly Capital Management and American Capital Agency -- which are two of the largest mREITs -- both held approximately $64 billion in agency MBSes, with an average yield on assets of 2.8%. 

How do mREITs buy MBSes?
Since mREITs pay out 90% of their earnings, these companies can't grow like normal businesses. Instead, mREITs use what are called repurchase agreements, or REPO loans, to borrow short-term and buy longer-term securities, earning the difference between borrowing costs and interest on securities, or the interest rate spread.

REPO loans work similar to collateral loans. Annaly Capital Management and American Capital Agency will sell MBSes to a bank or financier at a discount, or "haircut," with an agreement to repurchase the security at full price on a later date. The discount serves as the interest rate. In the meantime, these companies can buy more MBS with that cash.

Advantages and disadvantages of borrowing
How many times the company borrows against its equity is considered leverage. It works similar to a mortgage on your house. If you put down 20%, or $20,000 in equity, for a home that cost $100,000, you are leveraged five times. 

If the house was to increase in value by 10%, the home would be worth $110,000. However, since you only put down 20%, the return on your equity investment now sits at 50%. The downside is it works exactly the opposite if value decreases.

Annaly Capital Management and American Capital Agency will normally leverage between five and 12 times their equity. How much leverage is deployed depends heavily on the overall interest rate environment. This is because interest rates can effect borrowing costs, and the value of the companies' MBSes. 

The bottom line
The eye-popping dividend yields mREITs sport are enough to make any income investor salivate. However, dividends alone aren't enough to warrant an investment. This is why it's so important that you've now equipped yourself with the knowledge of how these companies work, giving you the tool to better evaluate, and make a more informed decision about these enticing investments.

Is this a better dividend option than mREITs?
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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