The Number That Threatens These Huge Dividend Yields

If you've perused a list of the top dividend yielders in the market, you know that the list is utterly dominated by real estate investment trusts (REITs).

My fellow Fool Eric Bleeker recently gave a general history lesson on why the biggest yielders don't necessarily stay that way.

There are specific risks, too. Many of today's high-yielding REITs make their money borrowing cheaply (the Fed is keeping those interest rates historically low) and buying longer-term mortgage-based securities. These are ideal conditions and even the most illustrious member of this group, Annaly Capital (NYSE: NLY), has only been operating since 1997. And even in that short time, its dividend payouts have been a rollercoaster. The highest-yielder of all, American Capital Agency (Nasdaq: AGNC), has only been around since 2008.

There are certainly risks in REITs, but if you're interested in them, I want to show you an initial step in evaluating them. Taking this step may highlight a key weakness in your favorite REIT. Before that step, take a look at the highest yielders; there are 13 REITs with market caps above $200 million that currently yield at least 10%.

Source: Capital IQ, a division of Standard & Poor's.

Now on to that step. Let's see how much leverage each of these REITs is employing. By leverage, I mean debt (as opposed to equity). In good times, leverage does wonders for a company's ability to generate profits (and keep up big dividend payments). Recall that the massive leverage Wall Street banks were using before the financial crisis was a key factor in their downfalls.

Below, I'm adding a new column to the table I showed you earlier. This time, I include an indication of leverage, using the assets-to-equity ratio.

Source: Capital IQ, a division of Standard & Poor's.

Using American Capital Agency as an example, it is supporting $11.40 of assets for every dollar of equity it has. Put another way, it has $10.40 of debt and other liabilities for every dollar of equity.

You'll notice that American Capital Agency leads the list not only in dividend yield, but also in leverage, creating a possible "the bigger they are, the harder they fall" scenario. Contrast that with Chimera, whose dividend yield is only a few percentage points behind but has an assets-to-equity ratio of just 2.5.

That's a pretty huge disparity. Chimera is being much more conservative when it comes to leverage.

Don't get too excited, though. This is just a first step in analyzing this list of high-yielding REITs. For example, consider that American Capital Agency invests in agency securities (hence the name) -- in other words, it invests in mortgage-backed securities that are guaranteed by an entity like Fannie Mae. With government backing, the risk of default is pretty much nil.

Chimera, meanwhile, primarily invests in mortgage-backed securities that aren't agency securities. So, it's employing less leverage but is investing in securities with greater default risk.

The takeaway
If you decide you're interested in high-yielding REITs (and that should be a carefully thought-out "if") this list can be a good place to start. We've isolated the REITs throwing off more than 10% yields and taken a look at the leverage they're employing.

That's a good first step, but there are many nuances within the business models and the balance sheets of these REITs, so do your research and tread carefully.

If you're looking for a good breakdown, we recently wrote a report highlighting five stocks that Motley Fool has bought for its own account. One of the five stocks is also on the list of high-yielding REITs above. If you'd like to see the entire buy thesis on that stock (as well as the analysis on the other four), I invite you to download it for free. Just click here.