There is a lot of justified fear concerning REITs. Mortgage REITs make money by using the spread between short-term debt and long-term debt. The fear for REITs stems from concerns of a change in the interest rate and continued easing pushing the interest rate spreads even lower. The Fed has been buying up mortgage-backed securities, increasing their price and lowering yields. That makes it hard for mortgage REITs to make money despite low short-term rates.
Regarding the low short-term interest rate, I give it at least two years before we see interest rates significantly higher. This is just based on the slowness of economic recovery and growth, and the soft labor market. Despite the flood of money from the Federal Reserve, inflation has not become an issue, yet. If we see interest rates rise significantly before 2015, then oops. You’ll have a warning one way or the other and you can exit your positions, because the rate will not rise to 4% overnight. It is likely to be incremental.
Still one of the best in its class
I might be boasting a bit too much on behalf of Annaly Capital Management, Inc. (NYSE:NLY), but I do think it is one of the best REITs to own. It is the one I am most familiar with, so take that into account because it puts some nice color on my opinion. When I started following Annaly, it was at $17-$18 a share. It is a bummer to see it at $15.50, but whatever position I used to have was closed when some covered calls got assigned. The decline in price has boosted the dividend yield to 11.60%.
You are looking for Annaly Capital Management, Inc. (NYSE:NLY) as a dividend stock, but over the last two years, the dividend has drifted downwards. This is due to a lot of factors that require an understanding of the complex business that a mortgage REIT operates. This is not a primer on that business. The company is to be liked for its overall stability and efforts to diversify itself. It is working on acquiring the rest of Crexus Investment Corp (NYSE:CXS) that Annaly Capital Management, Inc. (NYSE:NLY) does not already own. The negatives of the company stem from broader factors, not problems of the company itself.
You might consider a medium-term strategy that is active compared to traditional dividend investments. The aim is to collect the dividends, and to write covered calls to boost that amount. The lack of volatility will keep premiums low. If you end up being assigned in May, you want the move from the current mid-$15 range to $16 to give an adequate return. Therefore, this strategy is really only suited to someone with a large enough portfolio, so that they can own a lot of shares without overextending themselves.
Annaly’s diversity bid
Fundamental currents might warrant a standard long investment, if you believe that the company’s steps toward diversity will make it stronger. Annaly Capital Management, Inc. (NYSE:NLY) buys mortgage securities backed by Fannie Mae and Freddie Mac, referred to as agency securities. CreXus is a REIT that specializes in commercial paper, and that shot of diversity can be just what Annaly needs to stop its declining dividend.
To pay part of its dividend, Annaly has had to sell its securities at a gain. Rising prices on the securities depress yields. This is a less ideal situation than collecting returns off those securities to pay for the dividend. It would be like you are selling a stock to generate investment portfolio gains, because the companies in your portfolio are offering smaller dividends. That is a temporary fix until you are out of securities with gains to sell.
Adding CreXus to get into commercial paper is a good idea. It won’t even be that risky if the company sticks to investment grade paper. Annaly Capital Management, Inc. (NYSE:NLY) has been conservative in the past, so I assume it will remain that way.
The other good agency REIT
If you are looking for a strong dividend investment, then go with American Capital Agency Corp. (NASDAQ:AGNC). Annaly is my preference, because it has not done as well and is shaking things up. American Capital, on the other hand, has an epic dividend yield of 15.10%. Also, the 3-year return on the stock is 21%, versus Annaly Capital Management, Inc. (NYSE:NLY)’s (15)% 3-year return. Is this REIT just run better than Annaly, or perhaps, it is just a delayed effect compared to Annaly? For now, the facts are that American Capital Agency Corp. (NASDAQ:AGNC) is not cutting its dividend. There was one decline in early 2012, but Annaly has had more cuts.
American Capital is a pure play on mortgage REITs like Annaly. However, Annaly is aiming to become a hybrid with the addition of CreXus. It seems to be a good move for now, but you can never be sure. Also, it is not for sure that it will take CreXus. American Capital seems like the better choice if you are more skittish. Also, if you do not like betting that a change-up in the business will benefit Annaly Capital Management, Inc. (NYSE:NLY), then go with American Capital.
American Capital Agency Corp. (NASDAQ:AGNC) seems able to shrug off the issues Annaly is facing and offer its high yield, because it deploys more leverage than Annaly. However, the difference in the amount of leverage has been changing. American Capital’s leverage is declining, while Annaly’s has been increasing. One of the biggest things on the risk-side that differentiated the two companies is disappearing, and yet American Capital offers the better yields and stock performance. I consider Annaly Capital Management, Inc. (NYSE:NLY) the riskier play, even though in the past American Capital was considered riskier due to its leverage.
Putting it all together
It comes down to your specific strategy. If you are the quintessential dividend investor, then American Capital Agency Corp. (NASDAQ:AGNC) is your choice. However, if you look for companies that are shaking things up after showing some weakness, a.k.a turnaround stocks, then go with Annaly Capital Management, Inc. (NYSE:NLY).
The article REITs Are a Good Idea for at Least Two Years originally appeared on Fool.com and is written by Nihar Patel.
Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.