For investors searching for a strong total return, portfolio diversification, and a high-yielding income stream, Annaly Capital Management (NLY 0.59%) will likely find its way to the top of your list. However, because Annaly is far from the best opportunity in any of these categories, I think investors should be looking elsewhere.
More specifically, REITs Two Harbors Investment Corp. (TWO -0.88%) and Realty Income Corp. (O 0.24%) not only give investors a similar exposure to real estate with a high-yield, but they have significantly outperformed Annaly over the last three years -- and I believe that will continue.
Today I'll dig into why I like these companies and what gives them an advantage over Annaly looking forward.
Rising interest rates -- Two Harbors
With the Federal Reserve likely to increase the federal funds rate (short-term interest rates) in mid to late 2015, there's a strong possibility the market will see rising and more volatile long-term rates. Because rising rates lower the market value of Annaly's currently held securities, and volatility makes managing its portfolio more difficult, I see trouble ahead.
In fact, the last time there was a threat of the the federal funds rate being increased, 2013, there was a dramatic spike in the 30-year mortgage rate, and Annaly's book value took a tremendous hit.
To Annaly's credit, it has taken the appropriate measures to protect its book value this time around. However, while actions like lowering leverage -- borrowing less compared to equity -- are the right call, and it gives the company opportunity to increase borrowing when opportunity arrives, these defensive moves will likely lead to lower returns and smaller dividends. Moreover, because it's hard to say when "opportunity" will knock, I'd rather own a business that can create opportunity.
Two Harbors is one such business. While both Annaly and Two Harbors invest primarily in "agency" residential mortgage-backed securities -- pools of housing debt protected against default -- Two Harbors also invests in "non-agency" securities. Also pools of housing debt, but because these higher-yielding assets are more unique and not protected against default, their performance is much less linked to interest rates and tied more heavily to the health of the housing market and economy.
Ultimately, it's Two Harbors' diversity of assets that can perform despite prevailing interest rates -- along with a strong management team -- that makes it so versatile, and a more attractive high-yielding dividend investment.
More stable income -- Realty Income
Again, because of Annaly's susceptibility to interest rates, its dividend has been anything but stable over the past 17 years. So, for investors more interested in a stable income stream -- and willing to settle for about half the dividend yield -- equity REIT Realty Income and its 45-year track record of dividend stability is a good as it gets.
Instead of investing in securities, Realty Income owns 4,263 properties across the United States, which it leases to recognizable companies -- like Walgreens, FedEx, and Dollar General -- on long-term contracts. Moreover, because of the high quality of its assets, Realty Income did not cut its dividend even once during the financial crisis in 2008 or 2009.
Why settle?
Operating since 1997, Annaly has proven it can withstand market cycles. So, I don't see the company as a bad business, or a bad investment, and I think despite the threat of rising interest rates, Annaly will be fine over time. But why settle for "fine" or "not bad" when you can have great? Two Harbors and Realty Income are two great businesses, supported by fantastic management teams, and I believe they will provide investors with a much stronger total return.
