This REIT's Dividend Is Safe... for Now

These days, there's nothing investors love more than a big, fat dividend.

Perhaps no sector offers up larger dividends than real estate investment trusts. In order to maintain a tax-exempt status, these companies have to pay out at least 90% of their reported income in the form of dividends.

And perhaps no REIT is more widely followed or adored in Fooldom than Annaly Capital (NYSE: NLY  ) . Recently, fellow Fool John Maxfield (of whom I'm a big fan) has been poking holes in the company's ability to continue paying outsized dividends.

I intend to show that, over the next year or two, these holes aren't much to worry about.

The size of Annaly's yield
The first concern John brought up was the size of Annaly's dividend yield -- which currently stands at a whopping 13.9%. With its payout ratio at 124%, my fellow Fool believes that "Annaly has a duty to act as conservatively as possible without jeopardizing its REIT status -- that is, it should retain 10% of its net income each year."

And if net income were a solid number that represented cash on hand from operations, I'd agree. But the fact of the matter is, net income isn't the greatest tool for measuring money in versus money out for the company.

In fact, it's quite difficult to get a grasp on how to measure the sustainability of Annaly's payment -- more on why that's the case below. But if we were to take a look just at how much cash the company generated during the first nine months of 2011 through its normal operations, dividends only accounted for 36% of this total figure.

Secret exposure to risk
One of the comforts Annaly shareholders enjoy that other REIT investors don't is that the mortgages they're investing in are backed by the federal agencies (Fannie, Freddie, Ginnie).

But John rightly points out that Annaly also holds positions in Chimera (NYSE: CIM  ) and Crexus (NYSE: CXS  ) . These REITs only hold 47% and 21%, respectively, of their assets in federally backed mortgages. If the remaining mortgages were to go belly-up, Chimera, Crexus, and -- through their investments -- Annaly would be out of luck.

But if we look at the total size of those investments, we'll see that it's not as bad as it might seem. The value -- at today's prices -- of Annaly's investments in Chimera and Crexus is about $235 million, or just 1.5% of Annaly's total market capitalization.

Use of capital
The final purported notch against Annaly is how it's going about deploying capital. Specifically, John states, "The fact that Annaly pays out more than it earns while at the same time issuing new shares is evidence in itself of imprudent capital allocation."

Again, if we were talking about a normal company here, I would completely agree. But we're not; we're talking about an REIT. And this also relates to why it's so hard to measure Annaly's dividend sustainability.

With REITs, money is raised in order to take advantage of deals the real estate market is offering up. Annaly raises funds by issuing shares, leverages those shares through borrowing, and waits to deploy the cash on bargain-basement deals.

There are two huge advantages to doing this now: First, the cost of that leverage is super-cheap with interest rates so low; second, the housing market is still offering up some great deals. It's also important to note that currently, even with such low rates, the company's leverage is at historic lows.

I would qualify this as "opportunistic" use of cash, as opposed to "imprudent."

Ah, but here's the rub
This isn't to say, however, that I'm a raging bull on Annaly. In fact, I'm purposely not going to make a CAPScall on my profile for Annaly right now.

I don't think that Annaly's payout is particularly huge in terms of what the company is giving away. Rather, I think it represents a risk premium for investors. Most just aren't willing to pay too much for shares right now, and that is why the yield is so big.

For instance, should political winds shift to change the way Fannie, Freddie, or Ginnie back their mortgages, this could represent a huge change to Annaly's investment thesis.

Furthermore, an uptick in interest rates -- which doesn't seem likely now, but then again we're pretty bad at predicting the future -- could induce a double whammy: home-owners paying off mortgages early (which would reduce Annaly's return) as well as an increased cost of borrowing and narrowing of its profit spread. In fact, the company states that an increase in interest rates of 75 basis points would reduce interest income by 4.11%.

But probably the most concerning for shareholders would be a lowering of the long-term interest rates. That's where the Fed's Operation Twist plan comes in.

John points out, "The intended result of Operation Twist ... is to force short-term interest rates up and long-term interest rates down. That will narrow the interest rate spread that REITs rely on to make money and pay a generous dividend."

In the end, I'm far more likely to invest in dividend payers like Coca-Cola, Intel, and Johnson & Johnson -- three companies that I own and have made CAPScalls on. If you'd like to see a few more dividend payers that I believe represent good return for the risk involved, I suggest you check out our special free report identifying 11 rock-solid dividends for your portfolio. You can get access to the report today, absolutely free!

Fool contributor Brian Stoffel owns shares of Intel, Coca-Cola, and Johnson & Johnson. You can follow him on Twitter at @TMFStoffel.

The Motley Fool owns shares of Coca-Cola, Johnson & Johnson, Chimera Investment, Intel, and Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Johnson & Johnson, Intel, Annaly Capital Management, and Coca-Cola, and creating a diagonal call position in Johnson & Johnson. 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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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 25, 2012, at 1:43 PM, JohnMaxfield37 wrote:

    Hey Brian -

    Enjoyed the article! Thanks for the opportunity to spar.

    I have two points to make. The first deals with NLY's payout ratio and capital allocation. The second deals with the behavior of interest rates.

    I only deal with the first point here.

    You are exactly right about cash flow vs. net income -- as the latter isn't the best indication of a company's capacity to pay dividends. The big telecoms are an example of this, as they have massive non-cash depreciation expenses that offset net income while revenue continues unabated. While NLY doesn't have material depreciation to record, it's net income is reduced by non-cash mark-to-market accounting via its securities held for investment and interest rate swaps.

    Where you're off, is in your use of the free cash flow payout ratio to prove your point. In your analysis, you look at the "cash the company generated in the first nine months of 2011 through its normal operations" to produce a cash flow payout ratio of 36%.

    This is arguably inaccurate, as $5.4 billion of the purported cash flow you cite derived from the issue of new shares. In other words, it's not from what is typically considered the "normal operations" of a business, unless that business has a ponzi-like structure.

    Consequently, you have to take out that $5.4 billion, leaving NLY with a negative cash flow of $2.2 billion -- negative $0.7 billion if you don't include the dividends paid over the same period. This makes a cash flow payout ratio meaningless, because the denominator is negative.

    In other words, looking at cash flow as opposed to net income diminishes the main point in your analysis. Instead of providing support, it simply magnifies the problem, because it shows that the dividend payments couldn't have been funded with NLY's "normal operations."

    It's for this reason that I said NLY's capital allocation is imprudent. While I too may classify this as "opportunistic," I definitely wouldn't do so in a good way.

    - John

  • Report this Comment On January 25, 2012, at 10:19 PM, TMFCheesehead wrote:

    @John-

    Alright, lots of big numbers for this bear of small brain to chew on, but here's my try.

    The $5.4 billion is NOT actually listed under "cash from normal operations" on the balance sheet, it's listed under "cash flows from financing activities". Those are two separate things.

    I'm getting this from the company's most recent quarterly filing, page 4, under the 9 months ending in September. The $5.4 billion you're referring to is listed under "net proceeds from follow-on offerings."

    Here's the link: http://www.sec.gov/Archives/edgar/data/1043219/0001157523110...

    In the end, we both have the same general call on NLY, but I'd like to figure out where we're not meeting numbers wise.

    Brian

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