Annaly Capital Management (NLY 0.59%) is a real estate investment trust (REIT), a corporate structure intended to throw off a steady stream of income to shareholders. Add in the massive 11% yield the stock is offering today, and investors with an income focus might be tempted to dive in and start collecting a big quarterly dividend check. Don't do it until you fully understand these three risks.
1. A different kind of REIT
All REITs are not created equal. That's a big issue here because Annaly's focus is on owning mortgages, not physical property. While mortgages do have value, most investors likely think of buildings when they conjure up an image of a REIT. It is an important difference. If a tenant goes belly-up, a REIT with a building can simply find a new renter. From a bigger-picture perspective, if the financial system starts to go haywire (like it did during the deep 2007-2009 recession), there are actual physical assets underpinning the rent roll.
Image source: Getty Images.
A mortgage REIT, on the other hand, buys and sells pieces of paper. Generally that means collections of mortgages put into a mortgage bond. The company earns the difference between its cost of capital (the debt and equity it sells) and the interest rate on the mortgage securities it owns. While there are technically physical assets behind the mortgages involved, getting an individual property vacated and sold to salvage some value is not an easy task. And, if the financial markets go into a tailspin, the value of the mortgage securities in the portfolio could plummet and/or the bonds could become illiquid. That would leave Annaly and its shareholders stuck waiting for better days or, if things got really bad, it could be forced to sell assets at fire-sale prices.
These are worst-case scenarios, of course, but the Great Recession proves that they sometimes come to pass. And that downturn included the bankruptcy of a few once-sizable mortgage REITs.
2. Interest rates
Interest rates have an impact on the entire real estate sector. For example, low rates make raising capital cheap for property buyers using debt. Some REITs are taking advantage of this situation today and going on buying sprees. High rates, on the other hand, make it more expensive to raise money. That said, if a REIT buys a building and locks in long-term funding via a bond or equity sale, changes in interest rates aren't a major problem. The economics of that property are pretty much set. That's a simplification of a very complex issue, but it highlights an important point. The value of mortgage bonds, like all bonds, generally goes up and down as interest rates change, so the core value of Annaly's portfolio is highly variable. And, thus, its stock price will be highly sensitive to interest rate changes as well.
The extra volatility that can add is bad enough. But there's another problem when you deal with mortgages. People often refinance their loans when rates change. That's not usually a big issue when rates are rising, but when rates are falling, like they have in recent years, repayments can materially alter the economics of a bond. In other words, what once seemed like a great security can turn into a middling one if too many mortgages get paid off early. That's not to suggest that the desirability of a physical property can't change over time, but there's an inherent difference in the process and remedy. You can spruce up a building; there's little you can do with a mortgage bond that's not living up to expectations.
3. Some charts to pull it all together
Points one and two are high level. Investors looking to own reliable dividend-paying stocks just need to understand that Annaly is very different from a property-owning REIT. And, for most people, there are simply better options out there. That's particularly true for those with a conservative bent.
But often a picture can tell a story better than words alone. And that's painfully true here. The graph below charts Annaly's dividend and share price over the past 10 years. Notice the steady decline in both. The inherent problems with the mortgage bond focus noted above have clearly had an impact on investors.
What's interesting about this is that Annaly's dividend yield has stayed in the 10%-plus space throughout the last decade. In other words, the REIT's fat yield has looked attractive for a long time even though this investment hasn't been particularly good for shareholders. The logic is simple: As the dividend gets cut, the stock price falls. That keeps the yield high, but shareholders get a double whammy: Less income from an asset that isn't worth as much as it once was.
Even reinvesting the dividends doesn't do enough to salvage Annaly. Yes, buying more shares with the dividend pulls the total return up to around 55% over the past decade, but it still falls well short of other options. For example, the total return for Vanguard Real Estate ETF was 215% over the same span. There's really no comparison.
Not worth it
For most income investors, the risks involved with Annaly just aren't worth it. There is just too much risk and the company's history shows that the downside is considerable. Yes, this REIT has a huge yield. But that's not enough to make it a good investment.
