Annaly Capital Management (NLY -0.32%) is offering investors a huge 10% dividend yield today. To grasp just how big that is, the S&P 500 Index is yielding just 1.4% right now. The only problem is that a stock's yield doesn't tell the whole story -- and when it comes to Annaly, you really need to know the full story. Here are some key points to get a handle on before you step into this high-yield real estate investment trust (REIT).
1. The structure
One of the reasons why Annaly pays such a big dividend is that it is structured as a real estate investment trust. REITs are pass-through entities that avoid corporate-level taxation by delivering at least 90% of their earnings on to investors. Investors pay tax on the dividends at their normal income tax rate. It's not a bad deal, but investors need to understand that REIT dividends are not like regular corporate dividends.
That said, if you put an REIT into a Roth IRA, that income would suddenly become tax-free. So there are ways to deal with the tax issue, so long as you understand it going in.
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2. The focus
The next important fact here is that Annaly doesn't actually invest in physical property like a typical REIT. It owns pools of mortgages, which is a very different business than being a landlord. Essentially, Annaly earns the spread between its cost of capital and the interest it earns on its mortgage portfolio. While that sounds fairly simple, there's a lot going on under the hood here. For example, mortgage REITs like Annaly generally use their portfolios of loans as collateral for debt, which is used to buy additional mortgage securities.
This can boost returns, but leverage can also boost risk. Indeed, if the value of Annaly's portfolio falls, its lenders might ask for additional collateral. If that collateral isn't available, the REIT would have to liquidate investments at what would likely be a very bad time. This is infrequent, but when it happens it can be a bit shocking. Moreover, interest rate changes can have a notable impact on the income the REIT generates too, given that mortgages get paid off over time. Adding in new, lower-yielding securities means there's less income available to pay dividends.
The key takeaway is that Annaly isn't a simple company to understand, and unless you are willing to dig into your investments it's probably not a good choice for you.
3. The dividend
Since the dividend is what likely drew you to Annaly, it pays to get a handle on what to expect here. Over the company's history, the dividend yield has generally stayed between 10% and 15%, with a few spikes and valleys along the way. That sounds great, until you learn that the quarterly dividend has been as low as $0.10 per share and as high as $0.75 per share, with increases and cuts happening on a fairly regular basis. In fact, the quarterly dividend has been heading pretty steadily lower since peaking at $0.75 per share in 2009.
With so much variability in the dividend, the yield only stays so high because the stock price tends to change along with the dividend. Put another way, when the dividend gets cut Annaly's stock price usually falls, thus maintaining the high yield. If you are an income investor looking for a reliable dividend stream, this is not the stock for you.
4. Total return
Having said all of that, Annaly is probably best looked at as a total return investment, which means reinvesting the dividends over time (not living off of them). Some numbers will help here. Over the past decade, the total return from this REIT is around 60%, versus a stock-price-only loss of 50%. That's not only a huge difference, but an important one, too.
While a dividend investor would have collected dividends all along the way, the value of the investment would have basically collapsed. Notably, the dividend would have been falling over that span as well, so the income stream would have been declining along with the stock price. That's a terrible outcome for someone trying to live off of the income their portfolio generates. But the power of reinvesting at lower prices changes the math in a big way, as the total return figure shows.
You simply can't have your cake and eat it, too. You either need to look for a more consistent dividend stock or view Annaly as a total return play.
A unique investment
In fairness, Annaly is actually a pretty well-run mortgage REIT. For the right investor it is, indeed, worth a closer look. The problem is more about the mortgage REIT structure than Annaly. At the end of the day, these are unique investments that aren't appropriate for most income-focused investors. The yield may be enticing, but once you dig into the story, the math usually doesn't add up for anyone trying to live off the income their portfolio generates.
