High yields draw dividend investors like a flame attracts a moth. Sometimes, if the yield is just too high, investors can just as easily end up burned. That's the story when it comes to Annaly Capital Management (NLY 1.02%). Here's why most dividend investors should avoid this mortgage real estate investment trust (REIT), plus a reliable dividend REIT you might want to consider instead.
The problems with Annaly
Annaly's dividend has declined steadily over the past decade. Its dividend yield, however, has remained at around 10% or so (sometimes higher) over the entire span. Dividend yield and stock price move in opposite directions, so the only way that the yield has remained so high is that the stock price has tracked lower along with the dividend. This is a terrible outcome for any investor who bought the REIT expecting to use the income it generated for everyday living costs. The income it generates has plunged and investors have suffered a capital loss.
Data source: YCharts
There are a number of reasons for this, but a key factor is that Annaly is a mortgage REIT. This is a very complex niche of the REIT sector. These REITs buy what amounts to bonds backed by collections of mortgages, often called collateralized mortgage obligations, or CMOs. Leverage or debt, backed by the portfolio of CMOs, is usually employed as well. That materially increases the risk profile of REITs like Annaly, since CMOs trade daily and are impacted by external events, like property markets and changing interest rates. Unless investors are willing to dig deep into the way mortgage REITs operate, the dividend history here should be enough to keep most away despite the huge yield on offer.
The alternative
Far simpler to understand is a REIT like Realty Income (O -0.17%), which owns physical properties that it leases out to single tenants. Those tenants, meanwhile, are responsible for most operating costs of the properties they rent. Any one property is high-risk, but across the more than 12,000 buildings that Realty Income owns the risk is very low. Add in an investment-grade-rated balance sheet, and there's even more reason to feel secure about this REIT's dividend.
The strength of Realty Income really shows up, however, when you look at its dividend history. The REIT has been increased the dividend every year for 29 consecutive years. The dividend growth rate over that span has averaged around 4.4%, which isn't huge but is still very attractive as it is slightly higher than the roughly 3% average rate of inflation growth. Essentially, the buying power of Realty Income's dividend has increased over time. The dividend is also paid monthly, making it very close to a paycheck-like income option.
The problem is that Realty Income's dividend yield is only 5.2%. That seems tiny compared to the double-digit rates from Annaly, but it is still relatively attractive. For example, the S&P 500 index only yields 1.6% or so and the average REIT, using Vanguard Real Estate Index ETF as a proxy, yields 4.3%. Add in the slow and steady dividend growth from a financially strong REIT and the total package is pretty desirable. It is much more attractive than a high yield that history has proven investors can't count on.
The tortoise wins again
There are reasons some very specific investors (like insurance companies) might want to own Annaly. But most dividend investors would do well to avoid it, favoring more boring investment options instead. A great choice on that front would be Realty Income, which has proven over nearly three decades that its dividend is not only sustainable, but also capable of growing. Sure, Realty Income's yield is modest compared to Annaly's, but sometimes slow, steady, and boring is the better choice.
