If you are like most dividend investors, you prefer stocks with higher yields. There's nothing wrong with that, but it does mean you need to be careful not to get so enamored with a stock's dividend yield that you overlook the risks you are taking on. This is exactly what you need to consider when you examine Annaly Capital Management(NYSE: NLY) and its massive 13.9% dividend yield.
Here's why you probably won't be among the investors who want to own this ultra-high-yield real estate investment trust (REIT).
All REITs are not the same
Real estate investment trusts were created to give small investors the ability to participate in the institutional-level real estate sector. As an incentive, the business structure allows REITs to avoid corporate-level taxation as long as they pay out at least 90% of their taxable earnings as dividends. The caveat here is that shareholders have to count the dividends as regular income. Still, the sector tends to offer very generous dividend yields to investors.
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For the most part, REITs are pretty simple businesses. They operate similarly to the way you would operate if you owned a rental property -- a REIT buys a property and then rents it out. They are a good choice for investors looking to create a stream of cash to live off of in retirement. In fact, there are some REITs that have very impressive dividend histories, including Dividend KingFederal Realty(NYSE: FRT), which has over five decades of annual dividend increases under its belt. That's the type of payout you can comfortably rely on.
But not all REITs are simple, with mortgage REITs like Annaly Capital among the most complex you can buy. Annaly doesn't buy properties. Rather, it buys mortgages that have been pooled into bond-like securities, sometimes called collateralized mortgage obligations or something similar. Mortgage REITs usually use leverage in an effort to enhance returns, with the mortgage securities they own acting as collateral. That increases risk, because these securities trade openly and the prices can change pretty quickly at times, sometimes leading to what amount to margin calls. That can force mortgage REITs to sell assets at depressed prices to cover the call.
And then there is the issue of what can lead to the rapid changes in the value of the portfolio. There's investor sentiment, which impacts most investments. But the value is also affected by interest rate changes, housing market dynamics, mortgage repayment trends, and mortgage refinancing activity, among other issues. Some of these factors can be specific to a single year's worth of mortgages, too, so there's often material granularity to the risks. This is a complex business, and you should only invest in Annaly if you are willing to devote the time and energy to do a very deep investigative dive on the mortgage REIT model first.
The proof is in the dividend
Some investors might still be saying, "But look at the huge yield!" Yes, it is large, but that's because Wall Street has seen the dividend head mostly lower over the past dozen years or so. The stock price has followed the dividend down. Think about that for a second: If you are trying to live off of the income your portfolio generates, owning Annaly would have left you with less income and less capital. That's a painful double whammy.
The thing about Annaly is that it really isn't designed for small investors looking for reliable dividends. It is created for large investors that focus on total return (which assumes dividend reinvestment) and use an asset allocation model. That list includes entities like pension funds and insurance companies, with Annaly -- or mortgage REITs like it -- providing direct exposure to mortgage assets.
Tread carefully with ultra-high yields
Sometimes Wall Street does, indeed, throw the baby out with the bathwater. That can create unique income opportunities and very high yields. But whenever you see an outsize yield -- like Annaly's 13.9% -- you need to step back and carefully consider what you are buying. Sometimes the potential risks just aren't worth the potential rewards, which is likely to be the case for Annaly.
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Reuben Brewer has positions in Federal Realty Investment Trust. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
