When it comes to real estate investment trusts, or REITs, there are two very different kinds. There are equity REITs, which own commercial properties, and then there are mortgage REITs, which own mortgages and other financial investments. One of the most popular mortgage REITs is Annaly Capital Management (NLY 2.38%), which is not only a rather large mortgage REIT, but, with an 11% dividend yield, is also one of the highest-paying.
In this Nov. 25 Fool Live video clip, Fool.com contributors Matt Frankel, CFP, and Brian Feroldi discuss Annaly as an investment, the mortgage REIT industry in general, and what investors should know before considering Annaly for their portfolios.
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Matthew Frankel: NLY, that's Annaly Capital Management, is always a favorite of mine, good volume, great yield, long track record, any thoughts on NLY? Well, they are a mortgage REIT. They are different than the real estate stocks I'm talking about here. Their primary investment is they buy mortgages, mortgage-backed securities, things like that, and collect interest payments and profit from the difference between their cost of capital and what they're paying for mortgages. I'm not a mortgage REIT investor. I'm not that big of a fan of the business. It tends to be volatile in tough times, which looked back in a chart in March and April and it will make the down in S&P look pretty tame. But I will say that they are probably the best in breed. They're my favorite mortgage REIT out there and they thrive on stability. Mortgage REITs do their best business in stable environments. They don't want interest rates to spike higher too quickly. They don't want interest rates to fall too quickly. So if you think this is going to be a pretty stable environment then it could be a good time to look at mortgage REITs. But I'm generally more of a fan of what they call equity REITs, which are the real estate companies that own actual businesses.
Brian Feroldi: Yeah. Let me just touch on Annaly one quick second because I know this trips a lot of people up. I don't know a ton about Annaly. I do know that it always has a double-digit dividend yields. Like that's like the thing about it. That is really tempting, super tempting. But you have to look at total return, not just dividend yields. So let's do that. How has Annaly performed versus the S&P 500 over the last one year, lost, three-years, lost, five-years, lost, 10 years, lost. It doesn't look like a wealth creation machine to me. It looks like a company that uses share issuance to fund a dividend. It tricks people into thinking this is a great buy because it has a massive yield. I know that this is a fan favorite for a lot of people that seek dividends, but if you consider total return, which you should, it has been a loser over the long term.
Matthew Frankel: Yeah, I would definitely agree with that. The reason to be fair is because mortgage rates have generally been on a downtrend over that whole chart that you showed.
Brian Feroldi: Yes. Actually to be super fair, let's backup since this time and it has been a wealth creator. That's an excellent point. If you've bought this thing in 1998, hey, you've done really well.
Matthew Frankel: But just look at the volatility, look at how much the chart jumps around compared to the S&P overtime.
Brian Feroldi: Yes.
Matthew Frankel: So it's not a stable income machine. This is not a savings account with a 10% yield.
Brian Feroldi: It's just been a bad decade. Yeah. To me, I want to own things that have been in the market over the last five years. That's just where I look. This thing hasn't. May I turn around to Matt's point, which is completely valid, interest rates have been in the zero for the last 12 years essentially. I don't know if that works against the company or not. But the point is still valid, which is focused on total return, not just dividend yields.
Matthew Frankel: The general idea behind Annaly and all these mortgage REITs, just to give a little bit of the technicals, is the general business model is that they borrow money at cheap short-term interest rates, and buy mortgages that have 15 or 30 years, just like mortgages. Generally the longer-term duration your financial instruments, the higher the interest rate it's going to pay. So if they can borrow money at 2% and buy mortgages paying 4%, they get the profit from the difference. Then what they'll do is they'll borrow a bunch of money, and buy a bunch of mortgages, and use a lot of leverage to get these 10% yields. So if they have, say, a five to one leverage ratio, meaning for every dollar that investors put in they're borrowing $5 after getting a 2% spread on their mortgages, that's where your 10% yield comes from. The problem is from their short-term borrowing costs jump, you can see these profit margins go away really quickly. When interest rates fall really fast, you will see a lot of people prepaying their mortgages and these mortgage securities that they bought just disappear. So it's a risky business model in the short term. Like I said, it is not a savings account that has a double-digit yield. But over the long term it does have the potential to beat the market. But I wouldn't buy it as an S&P replacement. Know exactly what you're getting at. Look at total return like Brian said. Over the long term it's done well, but over the recent times it really hasn't because of all those reasons I just mentioned.
Brian Feroldi: if rates don't go up, yeah, it might be a sensational performer. I don't know it well enough. The point wasn't to say this is a terrible company. The point was to say you can't just look at one metric.