Annaly Capital Management (NYSE:NLY) is offering investors a massive 16% dividend yield today. Normally that should throw up a warning flag that there's something amiss. However, the real estate investment trust's (REIT's) yield has been 10% or higher for most of the past decade, so a fat yield isn't out of the ordinary. Even so, you shouldn't take too much comfort in that bit of information -- you need to know a lot more than just yield stats before you buy Annaly.

A high-risk approach

Annaly Capital Management is a mortgage real estate investment trust. It does not own physical property, just mortgages on properties. That's a lot different from a traditional REIT, which at least has the value of the properties it owns to fall back on in a worst-case scenario. If someone stops paying Annaly, it would have to go through an often-lengthy legal process (foreclosure) to actually get hold of the property it's helping to finance. Normally this legal backstop is not too big a deal, but during economically difficult periods it becomes a much more important factor to consider.

A man with his head on table and a graph behind him heading down

Image source: Getty Images

That said, Annaly buys massive portfolios of mortgages that are bundled together, so it doesn't usually get to the point where it's involved in the nitty gritty of a foreclosure -- someone else handles that. But it's still an important piece of the puzzle, because the bundles of mortgages it owns are priced in the market based on underlying fundamentals, which includes the likelihood of the mortgages in the bundle getting paid in a timely manner. When investors are worried about repayment risk, the value of Annaly's portfolio falls.

That, in turn, is a big problem, because Annaly uses leverage to juice its returns. The collateral for the debt it takes on is its mortgage portfolio itself. It's a lot like a margin loan that an investor might get from their broker. If the value of the collateral falls, the lenders -- in both situations -- will ask for more collateral or the repayment of the loan. So during times of economic uncertainty, like today during the COVID-19 pandemic, the value of Annaly's portfolio can decline, and it could be on the receiving end of a margin call. If it can't come up with the extra cash, it will have to sell parts of its portfolio. 

The important thing to remember here is that this isn't specific to the COVID-19 crisis. The same issue appeared during the 2007-to-2009 recession. This risk is inherent to owning a mortgage REIT like Annaly. The yield is so high today because the company's business approach of using leverage is out of step with the market environment, and investors are worried. If you can't stomach that type of uncertainty, you shouldn't own a mortgage REIT.

Not the only problem

Although that's a prominent concern today, that's just one issue that investors need to consider. Another big problem with Annaly's approach is that it's basically a spread investor. It makes the difference between its financing costs and the rates it earns on the bundled mortgages it owns. That's not inherently bad, but it means that falling rates can have a notable impact on the REIT's ability to pay dividends. 

It doesn't take much effort to see this risk in action. Annaly's dividend peaked in the fourth quarter of 2019 at $0.75 per share. It has basically fallen steadily since that time, in what has been a period of historically low interest rates, to a current quarterly level of $0.25 per share. The most recent dividend cut came in mid-2019, but with COVID-19 leading to material unemployment in 2020, there's a risk that Annaly's mortgage business is going to face some tough times in the very near future.

However, here's the interesting thing: Annaly's dividend yield has been in the double digits for most of the past decade, even though the dividend has been falling. The reason is that the stock price has fallen along with the dividend. 

If you had reinvested every dividend payment, the total return (price return plus dividend payments) would have been positive over the last decade. However, most investors looking at a big yield are probably seeking to maximize current income so they can live off of the dividends they collect. Total return isn't the name of the game for income-oriented investors, they want a combination of yield and safety of principle. And even if total return is what you're after, it would take a very strong constitution to sit idly by and watch the stock price drop as the dividend got cut.

NLY Chart

NLY data by YCharts

Now, that dividend leveled off at $0.30 per share per quarter for about seven years, during which time investors were able to collect a big yield and the stock held in a fairly consistent range. But the risk here shouldn't be overlooked, because when things get tough, mortgage REITs like Annaly tend to get hit pretty hard on Wall Street -- which is why the yield is so high today. And, unfortunately, there's a negative when rates rise, too: Investors will push the value of yield assets (like the pooled mortgages Annaly buys) lower to match the market's yields (since yield and price move in opposite directions). That can create problems because of the leverage the REIT takes on, as has been noted above. While an orderly increase in rates is manageable, a swift rise would likely be more difficult to navigate. Right now, though, as the economy deals with COVID-19, a recession is a much bigger concern.

A tough stock to love

At the end of the day, Annaly isn't an appropriate option for most investors. While it can provide reliable income when things are going well in the economy and market, during times of turbulence the bottom can quickly fall out from under its investment approach. That's a risk that's just too big for all but the most aggressive investors. If you are looking at Annaly because of its fat yield, you should probably hit the pause button and reassess your risk tolerance. Very few investors will have the stomach for owning a REIT like this.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.