Annaly Capital Management (NLY -0.32%) is one of the best-known mortgage real estate investment trusts (mREITs) investors can buy. And it sports a huge 13% dividend yield today! Only, there's more that investors need to understand when it comes to mREITs than yield alone. Here's why I will never buy Annaly and why you should be cautious, too.
The basic model
Most mortgage REITs buy pools of mortgage loans that have been lumped together into a single asset, often known as collateralized mortgage obligations (or CMOs in industry lingo). That, in and of itself, is not such a bad thing. These securities pay interest and principle to the owner over time, with the most notable "normal" negative being the risk of prepayments.
Prepayments reduce the principal of the CMO and leave the REIT looking for a place to put that cash. The problem here is that prepayments normally happen when rates are falling, so capital has to be put to work at lower rates. That's a fairly manageable issue that becomes less of a problem when rates are rising, as they are today.
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The other important risk is loans that go into default, which was a major headwind during the 2007 to 2009 housing-led recession. That's the issue that left me in the lurch when I owned a couple of mREITs. But the real problem here isn't the defaults, per se. The issue is more basic to the mREIT business model, which involves using leverage to increase the size of a REIT's CMO portfolio.
Essentially, mREITs like Annaly use the portfolio they own as collateral for loans they use to buy more CMOs. But the CMOs are assets that go up and down in value. So, when times get tough, mREITs can get hit with requests for additional capital to support their loans. It's like a margin call for an individual investor, and it can lead to massive portfolio upheavals. The big takeaway is that leverage limits financial flexibility, usually right when you most want that flexibility.
The track record
The biggest risk for dividend investors in all this is that the quarterly dividend check you are collecting may not be quite as secure as you think it is. For example, Annaly's dividend yield has been over 10% for most of the past decade. And over that same span, the dividend has fallen by around 60%. Yield and stock price move in opposite directions, so the stock price has to fall to keep the yield above 10% while the dividend payment is falling. Which is exactly what has happened here, with the shares also off by nearly 60% over that 10-year span.
If you are looking to build a consistent income stream off of which you can live in retirement, then Annaly is a terrible choice for your portfolio. What's interesting here is that I can't say Annaly is a bad company. For the most part, management does a good job. And for the right type of investor, the stock has been a net positive. Specifically, if you reinvest your dividends, the total return here over the past decade is nearly 35%.
You would have done much better in a diversified REIT exchange traded fund (ETF) like Vanguard Real Estate Index ETF. However, with Annaly's stock down nearly 60% but the total return -- which includes reinvested dividends -- up 35%, you can see that this isn't as bad an investment as it looks from the stock price alone. Yet, that's only true if you aren't looking to use those dividends.
And that's why I'll never buy Annaly. I am a dividend investor, and someday, I plan to start using that dividend stream to pay for my everyday living expenses. That's just not what Annaly and most other mREITs are built to do.
Know what you own
We all make mistakes when it comes to investing. The key is to learn from them. When I got burned by mREITs during the so-called Great Recession, it was because I didn't understand the real business model in play, which is not about providing investors with a reliable and growing dividend stream. Add in the leverage inherent to the business, and you can start to see why most dividend investors would be better off avoiding mREITs like Annaly.
