Colony Financial (NYSE:CLNY) is a finance company, structured as a REIT, that seeks out real estate-related investments across the capital structure and funnels its earnings through to investors in the form of high quarterly dividends.
Since rising interest rates have the potential to suppress the returns derived from fixed income investments, Colony Financial is an interesting income investment for investors who want to benefit from a diversified portfolio that's well insulated from interest rate increases.
In addition, Colony Financial's dividend yield of 6.6% (according to S&P Capital IQ) makes the company a valid alternative to other high-yield income structures, especially in the mortgage REIT space, where dividends can be less sustainable.
Colony Financial is a real estate investment and finance company, which is somewhat different from a classic mortgage REIT.
Mortgage REITs mostly invest in residential or commercial mortgage-backed securities, where cash flows from the underlying mortgage pools may or may not be backed by a government-sponsored entity such as Fannie Mae and Freddie Mac. Mortgage REITs rely on substantial amounts of debt to operate what can be called a "spread business": They use low-cost debt to finance the purchase of higher-yielding mortgage securities and pocket the difference.
Real estate-focused finance companies such as Colony Financial, on the other hand, are "focused on acquiring, originating, and managing a diversified portfolio of real estate-related debt and equity investments" (to quote the company website). Colony Financial also invests in distressed loans and facilitates recapitalizations.
In a nutshell, Colony Financial invests heavily in real estate assets across the capital structure (equity and debt) and looks for high risk-adjusted returns.
Low debt levels
Mortgage REITs usually depend heavily on debt financing. In fact, their entire business model is built on it.
Since mortgage REITs make a spread on their investments, they need to considerably lever up their balance sheets. This, of course, can substantially increase the risk for investors.
Finance companies don't rely as heavily on debt to push their investments. Colony Financial, for instance, has a substantially lower debt-to-total asset ratio than traditional mortgage REITs and, hence, has less risk.
Protected against rising interest rates
As investors know by now, the Federal Reserve is scaling back its bond purchases, which in turn will put upward pressure on interest rates across maturities.
Rising interest rates are generally not a good thing for fixed-income investments such as bonds or mortgages. If interest rates rise, the value of fixed-income investments goes down, because investors would now be able to invest in a new bond issue, for instance, at the higher prevailing interest rate.
As such, companies with investment portfolios that are somewhat protected from rising interest rates through an allocation of funds to equity and floating rate investments won't lose any sleep when higher interest rates really kick in.
In the case of Colony Financial, the company allocated 26% of its portfolio to loans with equity participation and floating rate investments. Only 12% of its investment portfolio consists of fixed-rate loans, which, by the way, carry a high average coupon rate of 12%.
Book value resilience
Last year was a rough one for mortgage REITs, and many saw hurtful declines in their book values in 2013. While Colony Financial wasn't exempt from increasing pressure on interest rates and REIT prices, it managed the ensuing storm much better.
At the end of fiscal year 2012, Colony Financial reported a GAAP value per common share of $18.30, which compares against $18.72 at the end of fiscal year 2013. That's a respectable 2.3% increase at a time when other high-yield income structures in the mortgage REIT business were bleeding serious book value.
Investors clearly like what they see, which is also why they reward shares of Colony Financial with a premium to its book value.
To my mind, investors who like recurring income and a high dividend yield benefit from Colony Financial's 6.6% dividend yield. And I think they are also taking on a little less risk compared with traditional mortgage REITs that are investing solely in mortgage securities and derivatives -- diversification being a generally good thing.
Kingkarn Amjaroen and The Motley Fool have 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.