Annaly Capital Management (NLY 0.59%) pays one whopper of a dividend. The company's payout currently clocks in at an eye-popping 16.4% yield. That's multiples above the S&P 500's dividend yield, which is currently 1.7%.
As tempting as that big-time payout might be, investors seeking a monster yield should first consider Medical Properties Trust (MPW -0.22%). That real estate investment trust's (REIT) 10.4% dividend yield is a lower-risk option than Annaly's massive payout.
The potential pitfalls of Annaly's ultra-high-yielding dividend
Annaly's business model plays a big role in its outsized dividend yield. The company operates as a mortgage REIT. It uses a combination of equity and debt to purchase residential mortgages primarily backed by government agencies. It makes money through what's known as the net interest margin, the difference between the average yield on interest-earning assets and its average economic cost of funds. The company can make a lot of money on this spread. Meanwhile, because it's a REIT, Annaly must distribute 90% of its taxable net income to investors via dividends to comply with IRS regulations.
The company strives to borrow money at lower short-term rates to buy longer-dated, higher-yielding mortgage-backed securities. This business model works well when there's a wide gap between the rate Annaly borrows money and the yield on its investments.
However, with the Federal Reserve increasing interest rates to cool off inflation, Annaly's average economic cost of funds is rising, shrinking its net interest margin. For example, its average cost of funds was 1.11% in the second quarter, while its net interest margin was 2.2%. Meanwhile, its average economic cost of funds increased to 1.54% in the third quarter, causing its net interest margin to compress to 1.98%. That shrinkage occurred even though its average interest-earning asset yield increased from 2.87% to 3.24% over the past quarter. Its margin could continue to compress in the coming quarters.
On a more positive note, the company currently generates more than enough income to cover its current dividend rate. However, if its net interest margin compresses too much, Annaly might need to reduce its dividend. That wouldn't be the first time the company cut its payout:
NLY Dividend data by YCharts
A healthier option
Medical Properties Trust has a much lower-risk business model. The company owns hospitals it leases back to operators under triple net lease agreements. Those leases make the tenant responsible for maintenance, real estate taxes, and building insurance. They also typically feature annual rental escalation clauses tied to the inflation rate. That means the healthcare REIT collects steadily rising rental income.
Analysts expect the company to produce $1.82 per share of funds from operations (FFO) this year. That gives the company an 83.3% dividend payout ratio, a reasonable level for a REIT. Meanwhile, analysts believe the company's embedded rent growth will offset recent asset sales and support $1.84 per share of FFO next year.
Medical Properties Trust has generated over $1.8 billion in cash from capital recycling transactions this year. In addition, it has signed deals to supply it with more than $650 million of proceeds in 2023. These activities have significantly improved the company's liquidity, giving it funds to repay debt, repurchase stock, or make selective accretive acquisitions.
That puts the company in a solid financial position heading into 2023. It has a relatively low leverage ratio of 5.8 times and credit ratings straddling investment grade. Meanwhile, it only has $446.8 million of debt maturing in 2023, which it could refinance or pay off through a combination of cash on hand (it had nearly $300 million at the end of the through quarter) and its upcoming asset sales proceeds.
These features put Medical Properties' big-time payout on a more solid foundation.
Go with the more sustainable option
While Annaly's big-time dividend seems appealing, there's a high risk the company could reduce its payout again if interest rates rise too sharply. So yield-hungry investors should first consider Medical Properties' payout. It's a much healthier option since the company generates stable and predictable rental income, has a reasonable payout ratio, and has a solid balance sheet.
