ARMOUR Residential REIT (NYSE:ARR) is a real estate investment trust that buys mortgages and mortgage-backed securities. It also currently pays a nearly 15% dividend.
Now, many investors are naturally skeptical of stocks with such high payouts, but there is good reason to believe that the dividend will be sustained in the future. Not only that, but after falling by about 5% over the past few weeks, ARMOUR is now trading for a nice discount to the value of its assets. But is that for good reason? Or does the stock have the potential to soar moving forward?
What ARMOUR invests in, and how it makes money
Mortgage REITs make their money by buying mortgages or mortgage-backed securities. ARMOUR's portfolio strategy has been to dispose of the longer-term 30- and 25-year mortgages on its balance sheet in favor of 15-year and 20-year fixed-rate mortgage securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae.
Because shorter-term mortgages don't pay as much as longer-term ones, ARMOUR's portfolio yields 2.86% on average. This may sound like a paltry return at first, but mortgage REITs use the power of leverage to dramatically boost their returns.
Since ARMOUR can borrow money for less than it receives from its investments, it can pocket the "spread" between the two rates. As of the second quarter, the company's cost of funds averaged 1.40%, so the net interest spread is 1.46%.
And ARMOUR employs a relatively high leverage ratio of 7.9-to-1, meaning that it borrows $7.9 million for every $1 million in capital it has. There are some mortgage REITs with higher leverage, but ARMOUR's is definitely on the higher end. For comparison's sake, industry leaders Annaly Capital Management and American Capital Agency both use leverage ratios of about 5-to-1.
Risky, but cheap
Admittedly, mortgage REITs are a risky investment by nature, because of their high use of leverage and susceptibility to interest rate swings. And, with a higher leverage ratio than many of its peers, ARMOUR is even riskier than most.
However, the valuation definitely takes that into account. ARMOUR currently trades for just 74% of its book value, an even deeper discount than its peers. Annaly Capital Management and American Capital Agency trade for 85% and 84% of book value, respectively.
So, even though there is a lot of risk associated with ARMOUR (interest rates could spike and/or a dividend cut could be necessary), it's pretty hard to ignore a company whose assets you can by for a 26% discount.
How it can offer such high returns
At first, it may seem like the math doesn't quite add up. ARMOUR earns an average net interest margin of 1.46% on its investments, and uses a leverage ratio of 7.9-to-1. So, some quick multiplication shows that the company should be earning a return of about 11.5%, well below the nearly 15% it pays out.
However, the leverage ratio is based on the value of the shareholders' equity, which as of the end of the second quarter was $4.90 per share. So when you account for the fact that shares trade for just over $4, the 11.5% yield on equity becomes about 14%.
Real estate investment trusts are required to pay out at least 90% of their income to shareholders, and the current dividend is substantially higher than 90% of the company's income. In fact, it is slightly more than 100% of the net income, but that doesn't necessarily imply that a dividend cut is on the horizon.
When it comes to mortgage REITs, paying out slightly more than 100% of their taxable income isn't necessarily a negative sign, since overages and shortfalls can carry over from previous quarters. For instance, ARMOUR estimates its taxable income for the most recent quarter to be $0.13 per share, two cents shy of the $0.15 in dividends it paid out. However, if it earns $0.17 per share for the next quarter, as some analysts are calling for, it can balance out the current quarter's shortfall. Mortgage REITs tend to try to keep their payouts as close to 100% as possible, so sometimes they overestimate and sometimes they underestimate.
And, if the dividend does get cut, it's likely to be very small, as the company is required to pay out most of its income. Still, the company's cheap valuation and high return potential could make it a risk worth taking.
Know the risks before you dive in
Before investing in ARMOUR, or any mortgage REIT for that matter, be aware that such a high dividend doesn't come without substantial risk.
To borrow money cheaply, ARMOUR borrows on a rather short-term basis, with average maturity of just 58 days, so the company is highly susceptible to interest rate fluctuations. For instance, I mentioned that the company's mortgage portfolio pays an average yield of 2.86%. Well, if ARMOUR's cost to borrow money jumps from 1.4% to 2.4%, the profit margin can erode very quickly.
Now, mortgage REITs do use some complex methods of hedging against rate spikes, but there is still a great deal of risk, especially against sudden increases.
Still, the high yield offered by ARMOUR, as well as its fantastic discount to the value of its assets, makes it seem to be worthy of consideration. Just know that while investing in ARMOUR could be very rewarding over the long run, you're likely to experience a lot of volatility on the way there. However, if you have a relatively high risk tolerance and a reasonably long amount of time to let your investments grow, ARMOUR could turn out to be a big winner for your portfolio.
Matthew Frankel owns shares of Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.