If you're investing for income, real estate investment trusts, or REITs, are a great way to get it. However, you have a basic choice when it comes to choosing individual stocks. You can choose REITs which primarily invest in properties, such as National Retail Properties (NYSE:NNN), or one that invests in mortgages like ARMOUR residential REIT (NYSE:ARR). These are two very different kinds of investments, so which one is the better fit for your portfolio?
How ARMOUR makes its money
ARMOUR residential invests in mainly fixed-rate mortgage-backed securities, all guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. Even though mortgage interest rates are low right now, ARMOUR uses substantial leverage in order to produce a high level of income for its shareholders, currently paying an annual dividend of about 13.5%.
ARMOUR's loan portfolio pays an average of 3.19%, and the company's cost of funds is about 1.37%, producing a net interest spread (profit) of 1.82%. ARMOUR currently uses a leverage ratio of just over eight to one; so theoretically, it should produce total income of about 14.8%. Since REITs have to pay out 90% of their income to shareholders, that's where the 13.5% dividend comes from.
National Retail Properties lets you buy property without the legwork
Unlike ARMOUR, National Retail Properties invests primarily in tangible real estate. The company acquires, develops, and leases properties for various retail purposes on a triple-net lease (or NNN, hence the ticker symbol) basis.
Basically, this means the tenants are responsible for all taxes, maintenance, and insurance expenses related to the property. This is a great way to eliminate these variable costs of ownership and produce a consistent, predictable income stream.
National Retail Properties allows investors to get into the lucrative world of commercial real estate without having to buy an actual property and find tenants. The portfolio is very diverse, consisting of 1,860 properties spread across 47 states. Many are leased on a long term (10 years or more) basis, and many of the tenants are stable, national companies such as CVS, LA Fitness, and Kangaroo gas stations.
What are your objectives?
The right choice for you depends on two things. What do you hope to achieve with your investments and how much risk are you willing to take on?
If your goal is to simply create a current income stream, ARMOUR looks to be the clear winner, as its 13.5% dividend is more than triple the 4.4% annual yield of National Retail Properties. If you can deal with the risks involved (more on that in a bit), the income from mortgage REITs is excellent for those who are retired or close to it, or investors who simply would prefer to have more income to invest elsewhere.
However, if your goal is to grow your portfolio over time, property REITs might be the way to go, and National Retail Properties is one of the best-in-breed. Not only does National Retail Properties pay a very nice income stream which can compound over time, it also seeks to produce long-term growth as the values of the properties increase over time.
When you consider that over the past 15-years, National Retail Properties has averaged annual total returns (share price plus dividends) of 15.9%, the mortgage REITs don't look like such a clear winner anymore. Also, bear in mind that those 15 years included the worst real estate collapse in recent history, which makes the high average returns even more impressive.
As property values rise and the company can charge its tenants higher rent. So, even though the dividend may seem small in comparison to ARMOUR's, a growing income stream could be the better option, especially if you have a long time frame to invest. National Retail Properties has raised its dividend for 24 consecutive years, so you can be pretty confident it'll continue to rise in the future.
How much risk can you take on?
Mortgage REITs have the highest potential for return, but they also have a lot of risk, mainly due to their high use of leverage. Specifically if the aforementioned interest spreads narrow, their profits can dwindle in a hurry.
However, since the share prices of mortgage REITs are tied to their dividends, there is the potential of very high total returns if market conditions are favorable. For instance, if ARMOUR's profitability (and dividend) were to rise by 10%, you could expect the share price to experience a similar gain.
On the other hand, property REITs like National Retail Properties have much lower risk. Basically, their risk is limited to the ups and downs of the real estate market. If property values fall by 5%, you could expect a similar drop in the share price.
Which is right for you?
In a nutshell, ARMOUR would be the best choice for those with a decent appetite for risk and want income now. If you're trying to grow your portfolio over time, and don't want to deal with volatile ups and downs, a property REIT like National Retail Properties could be a great addition to your portfolio.
Matthew Frankel 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.