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10 Common Misconceptions to Avoid With These High-Yield Stocks

By Dave Koppenheffer - Mar 18, 2015 at 8:03AM

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Mortgage REITs can be tricky. Here's what you need to know about these high-yield stocks.

With yields soaring beyond 10%, mortgage real estate investment trusts, or mREITs -- including Annaly Capital Management (NLY 0.75%) and American Capital Agency (AGNC 0.80%) -- are attractive income investments. But they are also highly misunderstood.

To be successful investing in mREITs one must look through the right lens and shed these ten common misconceptions.

1. mREITs are like normal companies
Nearly all misconceptions about mREITs come from this belief, that mREITs can be thought of like typical companies.

mREITs are more like investment funds than anything else, and once you grasp that concept you can relax, because everything you could ever want to know about mREITs will stem from that one idea.

2. mREITs are like equity REITs
REITs payout 90% of their taxable income to shareholders in dividends, and, in return, pay no tax on the earnings they distribute -- but that is about where the overlap ends.

Equity REITs own physical properties which they lease to businesses, while mREITs own and manage portfolios of real estate debt -- commercial or residential mortgage loans and bonds. 

3.mREITs control their yield 
A company's dividend yield is just a math problem: Annualized dividend per share (most recent quarter) divided by current stock price. 

Dividend Yield-March 2015-Annaly and American Capital Agency
Company Annualized divided Divided by Stock price Dividend Yield
Annaly Capital Management $1.20 / $10.50 11.4%
American Capital Agency $2.64 / $21.14 12.5%

Source: Yahoo finance and Nasdaq

Stock prices are controlled by the market, so investors (as a collective group) have the most influence over a company's yield. As a general rule of thumb, the higher a mREITs' yield, the riskier investors believe the investment is. 

4. mREITs are all the same
While mREITs focus on similar securities, their investment approaches, and the risk profiles of their assets, can vary dramatically.

Annaly and American Capital Agency, for instance, invest in agency mortgage-backed securities, which come with an implicit guarantee against default -- meaning if the borrowers stop paying, they are reimbursed for the difference. On the other end of the spectrum, some companies own subprime mortgages -- risky loans to borrowers with iffy credit, which you may recall played a role in the financial crisis in 2008.

mREITs belong in the same family, but each individual company should be viewed as a unique entity. 

5. Growth is always good
Because mREITs payout the majority of their income, they do not have the luxury of retained earnings like typical companies. For this reason, mREITs use significant amounts of debt -- three to ten times their equity on average -- simply to operate on a day-to-day basis. To grow will often mean taking on even more debt. 

So, while growth can be good, it can also mean that the company is taking more risk. In short, don't expect mREITs to grow like typical companies. 

6. Management is part of the company 
Both Annaly and American Capital Agency use external managers. This means instead of management being inside the company, they work for a separate entity that operates the business -- and this is normal among mREITs. 

Unlike typical management teams which are compensated based on company performance, external managers are treated like fund managers and earn a flat percentage of assets under management or shareholder equity. This is important to watch, as having an external manager can misalign the interests of shareholders and management.

7. Net income is the best way to judge earnings
Net income has its place, but it often does a poor job telling the whole story. For instance, Annaly's net income was negative $914 million in 2014, yet the company paid $1.2 billion in dividends during the year -- this is a nice tip-off something weird is happening.

As investment companies, mREITs will take substantial unrealized gains and losses on their investments. Some are accounted for in net income, and some are not, and this tends to throw net income out of whack. "Comprehensive income" accounts for everything, and is more useful for judging performance.

8. The price-to-earnings (P/E) ratio is useful
Divide a typical company's stock price by its net income per share and you get one of the post popular and widely used valuation metrics on the planet, the P/E ratio.

But since net income is not the best indication of an mREIT's profitability, this metric is fairly useless. Instead, mREITs will trade based on their price-to-book ratio -- which is a common metric for banks. 

9. Rising interest rates are bad 
In general, mREITs own real estate debt that is packaged into bonds. Because the market value, or price, of bonds falls when interest rates rise, mREITs can take significant losses on their securities. 

However, since mREITs earn the yield from their securities, when interest rates rise it can create opportunities to buy new assets at higher yields, and potentially improve future returns. 

What's important to remember is that the impact of rising and falling interest rates is not as black and white as it seems. 

10. mREITs are too complex and risky for the average investor
This is ridiculous. Until you learn the rules and get to know the companies, every business is too complex, and every investment is too risky. In this way, mREITs are exactly like every other company.

Get to know the individual companies, take a long-term approach, avoid attempting to time the market, and you can be successful investing in high-yield stocks.  

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool recommends Apple and Bank of America. The Motley Fool owns shares of Apple and Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Annaly Capital Management, Inc. Stock Quote
Annaly Capital Management, Inc.
$6.69 (0.75%) $0.05
AGNC Investment Corp. Stock Quote
AGNC Investment Corp.
$12.54 (0.80%) $0.10

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