Broadly speaking, individual investors who like real estate investment trusts (REITs) tend to have a focus on income. That's exactly what REITs are designed to produce, so this makes sense. However, you need to understand what you own because all REITs are not created equally. That's particularly true when you consider names like Annaly Capital Management (NLY 0.87%) and Armour Residential REIT (ARR 1.28%) because of their double-digit yields.
These yields are shockingly high
Annaly's dividend yield is currently around 14%. Peer Armour REIT sports an even higher yield of over 16%. If you like dividends, those figures probably sound pretty enticing. Perhaps too enticing.
And yet, by passing on at least 90% of their taxable income to shareholders as dividends, REITs are specifically designed to provide notable dividend payments. So maybe those elevated yields aren't as troubling as they seem? For most income investors, where reliable dividends are a key piece of the investment thesis, the risks are simply too high to bother with either of these two mortgage REITs.
Effectively, both Annaly and Armour buy mortgages that have been pooled into securities known as collateralized mortgage obligations, or CMOs in industry lingo. This is very different from a REIT that owns physical property. CMOs are actively traded assets that go up and down in value along with interest rates. When rates rise, the value of a CMO falls so that the yield remains equal to current rates (like a bond, yield and price move in opposite directions). That means the value of what a mortgage REIT owns is at risk of declining in value right now as the Federal Reserve is in a rate hiking phase.
But that's not the only problem. Mortgage REITs use leverage to buy assets, often relying on the value of their CMO portfolios as collateral. So when the value of the CMOs they own falls, they may end up having to provide more collateral, or worse, sell assets to reduce leverage. Selling assets can mean reducing the income a mortgage REIT generates, thus reducing the company's ability to pay dividends. Meanwhile, higher rates also increase borrowing costs.
This is not an academic issue, it's a very real one.
The dividend history
Annaly is generally considered a very well-run mortgage REIT. So this isn't a call on the company itself, per se. But if you are looking for a reliable dividend stream and hoping that the stock's 14% yield will juice your cash flow, you are likely to end up disappointed. The REIT cut its dividend in 2010, 2011, 2012, 2013, 2019, and 2020. The interesting thing here is that, similar to bonds, dividend yields move in the opposite direction to stock prices. Throughout these cuts Annaly's yield remained near or above 10%, which means the stock price fell along with the dividend. That's not a great outcome for an investor looking to live off dividends.
The same basic story holds for Armour REIT. This monthly pay mortgage REIT cut its dividend in 2011, 2012, 2013, 2015, 2016, 2017, 2019, and 2020. Like Annaly, the yield has been material the entire stretch, which means the stock price has been declining along with the dividend. This is a terrible outcome for income investors, given that the cash they receive is falling and, at the same time, the value of their portfolio is declining.
Mortgage REITs are not terrible investments, as this information would suggest to most income investors. They just need to be owned by the right kind of investor. And you do have to distinguish between mortgage REITs. Specifically, Annaly's total return, which includes reinvesting dividends, over the past decade is 15% (that's not an annualized figure) even though the stock has fallen over 60%. However, Armour's total return is negative 55% while the stock is down even more, with a loss of nearly 90% over the past decade. If a mortgage REIT fit into your broader asset allocation plan and you had to choose between these two mortgage REITs, Annaly is probably the better call.
Most should avoid the m-REIT space
Mortgage REITs are not a good investment choice for most income investors. Annaly and Armour are just two examples from the niche. And with interest rates on the rise, these two companies and many others face additional headwinds that will likely make paying reliable dividends even more difficult. In fact, it wouldn't be surprising at all to see more dividend cuts in the future. There are better dividend options.
