Digital Realty Trust (NYSE:DLR) and AMROUR Residential REIT (NYSE:ARR) are two very different REITs that could be exactly what your dividend portfolio needs. To decide which is best for you, let's break each company down and determine the upsides, the risks, the advantages, and the disadvantages of each.
What do these REITs do?
Digital Realty Trust buys, develops, and leases real estate used for specialized technological purposes such as data centers, technology manufacturing centers, and Internet gateway properties. With the explosion in cloud computing and big data, this niche of the real estate market has proved to be a great place for Digital Realty to do business. Beyond the complex technical requirements of these types of properties, the business model itself is pretty simple. Buy, develop, and lease. Its dividend is currently 4.60%.
ARMOUR Residential couldn't be any different. ARMOUR is a mortgage REIT (mREIT), meaning that it invests in mortgage-backed securities rather than directly in the real estate itself.
ARMOUR's business model is somewhat similar to a bank's. ARMOUR profits by borrowing money and then investing in securities composed of large groups of mortgage loans. The difference in their investment yields and cost of funding is their profit, such as how banks earn money on the spread between deposits and loans.
Banks, however, have a few advantages that mREITs lack. Banks can cross-sale products to their customers, diversifying their revenue streams and boosting returns. Also, banks are able to invest using cash from customer deposit accounts, a reliable and cheap source of funds. ARMOUR and other mREITs don't have those alternative income streams, and they must borrow from the capital markets to fund their investments, a riskier and more expensive funding model.
ARMOUR sports a lofty 18.8% dividend yield, but it comes with a catch.
Making sense of ARMOUR's huge dividend
A company's dividend yield is a calculation based on both its dividends paid and its stock price. In the case of ARMOUR, its high yield is a reflection of both a plummeting stock price and decline in dividend payouts.
The stock is down 33% over the past year, and the dividends paid have moved in lockstep. While the yield is high, the stock is clearly moving in the wrong direction.
In contrast, Digital Realty's performance has been much more stable. The stock is up just under 5% over the past year, and the dividend payouts have increased just under 2%, calculated on a trailing-12-month basis.
Which REIT is better for you? Breaking down the pros and cons of each
In my view, the most attractive characteristic of Digital Realty is its niche in the highly desirable data center market. Thanks to innovations in cloud computing and big data, industries from across the spectrum today require properties just like those Digital Realty offers. From traditional tech players to healthcare and even to finance and manufacturing, demand for data centers is poised for strong and steady growth.
Digital Realty's properties are oftentimes highly customized, with tenants investing large sums of their own capital to install specific, proprietary technology, sometimes before the property is even finished. This translates into high occupancy and retention rates.
As of November of this year, the company's properties were 93% occupied, retention rates hover around 80%, and leases include 2%-3% annual rent increases, with average remaining terms of 6.2 years.
That said, Digital Realty is not a risk-free prospect. The company reported $4.7 billion in debts at the end of the third quarter. Most REITs come with a high leverage ratio, given the nature of the real estate business, so Digital Realty is not unique in this regard. Digital Realty's fixed-charge ratio, a measure of its cash flow to debt service, was 3.5 as of November, a more than adequate ratio. Even so, it's still important to recognize debt for the risk it is, even in a capital-intensive business like real estate.
Another key consideration is Digital Realty's acquisition of another tech-focused real estate company, Telx, for more than $1.9 billion in October. This acquisition will help to accelerate growth and improve Digital Realty's property mix to meet evolving market demand, but there's no guarantee that the purchase of Telx will work out financially or operationally. The stock jumped about 15% on the news of the acquisition, but it's still too early to tell if the company paid a good price and if it will be able to successfully integrate Telx into its operations.
What about ARMOUR Residential?
ARMOUR Residential's stock is priced quite low right now, but that doesn't necessarily mean that now is the time to buy. Investors are concerned that the company and other mREITs will struggle to remain profitable when interest rates rise.
mREITs use short-term loans from the capital markets and invest them in longer-term assets in the form of mortgage-backed securities. That disconnect in time can expose the company both to tightening profit spreads and asset writedowns when rates rise (remember that yield and price move inversely in the bond market).
It is possible, though, that management at ARMOUR has appropriate hedging strategies in place to mitigate the interest rate risk on the company's balance sheet. If that is the case, then the market may have overreacted, sending the stock down further than necessary.
After several quarters of shrinking margins, the company's interest-rate spread looks to have reversed in 2015, and the stock's decline leveled out beginning in September. But again, there is no certainty that either of these trends will continue as the Federal Reserve raises interest rates, even if both are positive signs that the company is effectively managing costs and yields.
These positive signs don't change the fact that ARMOUR is highly leveraged and highly sensitive to interest rate risk. No one knows how the Fed will raise rates or how the capital markets will react when it happens. As such, today's environment is an inherently uncertain and risky time to bet on mortgage REITs.
And the winner is ...
So which of these two REITs is best for you? Your mileage will vary, of course, but in my view, Digital Realty is the safer and better choice, thanks to its niche in the market and stability over the past year. It's less sensitive to interest-rate risk than ARMOUR and still provides plenty of upside.
For those with a higher appetite for risk, I do think ARMOUR Residential represents a higher reward potential because the stock has been pushed so far down in anticipation of rising interest rates. To me, however, there's just too much uncertainty and risk to justify the potential reward of an investment in the mREIT space today.
Jay Jenkins has no position in any stocks mentioned. 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 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.