Annaly Capital (NLY 1.69%) has a towering dividend yield of about 13.9%. If you are looking to maximize the income your portfolio generates, that probably sounds pretty enticing. Sometimes things that sound too good to be true are, in fact, too good to be true. And this mortgage real estate investment trust's (REIT's) performance over the past decade is proof of that.
Not a bad M-REIT
Before getting too far here, it is important to note that Annaly isn't a bad mortgage REIT. In fact, it's fairly well-respected. That, however, doesn't mean it has been a good choice for income investors. All of the numbers suggest that it has been exactly the opposite.
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For example, the stock price over the past decade has fallen roughly 65%. That turned a $1,000 investment into just under $320 over the past 10 years. That's a terrible performance, though there's that huge dividend to consider. What happened if you reinvest that cash and bought more shares, which is the total return?
In that case, your $1k investment would now be worth $1,030! You didn't misread that; even including the dividends, investors buying this huge yield would have come away with a gain of just $30. The interesting thing is that the yield has been 10% or higher for most of the past decade. Because stock price and dividend yield move in opposite directions, that should cause some questions. The big answer is that the dividend payout has been falling, too, effectively leading the stock price down, thus maintaining the massive yield.
A double hit
The end result is that any investor who bought Annaly hoping to cash in on big dividend checks wound up with smaller and smaller checks and a steep decline in the value of their investment. That's a terrible outcome. This isn't all management's fault.
As noted, Annaly is a mortgage REIT. Typically REITs buy physical properties that are then leased out to generate reliable cash flows. Mortgage REITs like Annaly buy mortgages that have been grouped together into bond-like securities called something like collateralized mortgage obligations (CMOs). Standard REITs are in a very different line of business because properties generally trade infrequently and the assets have some intrinsic value (at the very least, from the property under the building, if not the building itself). Although mortgages are backed by property, the real value in them is in the expectation that property owners will continue to repay.
Adding to the complexity is that CMOs trade on the open market. So interest rate changes result in changes to the value of the CMOs. Although pricing can get complex, the simple logic is that when interest rates go up, older CMOs fall in price so that their value reflects the higher-yield environment. If that didn't happen, nobody would buy the older CMOs. On the flip side, there's rate risk in the opposite direction. That's because falling rates often lead to mortgages being refinanced, which shrinks the pool of loans in a CMO and reduces the cash it generates, lowering its long-term appeal. Although the loan payoffs pass through to the CMO holder, that cash has to be reinvested in new CMOs at lower rates.
There's another layer here, too, because most mortgage REITs also use leverage to enhance returns, earning the difference between their cost of capital and the interest paid on the CMOs. The loans are normally backed by the value of the CMO portfolio, so changes in interest rates, the housing market, and simple investor sentiment can all lead to negative outcomes for mortgage REITs. These are complex investments that aren't appropriate for most investors, particularly those seeking reliable dividend stocks.
Maybe things will turn for the better
The past decade, which was characterized by historically low interest rates, was not an easy one for mortgage REITs. So Annaly's performance isn't exactly shocking. And there's a chance, now that rates are moving higher, that Annaly's business will start to pick up after a transition period in which it adjusts to the new rates. Note that the past year's interest rate increases damaged its existing investment portfolio, and the REIT's book value fell by roughly 35% in 2022.
Even if you have a positive outlook, though, most investors should probably avoid this highly complex dividend stock in favor of property-owning REITs that have simpler businesses.
