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Financial residential REITs offer some of the best dividend payouts in the market. However, as with all high yielding instruments there can be questions raised over the quality and sustainability of their payouts.

Most investors will often stay away from companies that offer yields significantly above the market average as this usually indicates an imminent dividend cut. Yields over 10%, like the majority of Financial REITs, should be viewed with extreme caution.

So, are the dividend payouts from the five biggest and highest yielding REITs in the sector sustainable?

Financial REITs rely on leveraged products to produce the income they provide, which gives the companies very strange looking cash flows as they constantly restructure their debts and mortgage instruments. As a result, rather than comparing the dividend payout to the free cash flow, I am comparing the dividend payout to the net operating cash flow, as the free cash flow has been significantly distorted through debt and leveraged portfolio re-balancing.

Two Harbors Investment Corp. (NYSE:TWO)

Share Price

EPS

Dividend

Yield

Dividend Cover

$12.5

$1.2

$2.2

17.6%

0.5

Cash Flow Statement

$US millions

2010

2011

2012

Net Operating Cash Flow

33.11

151.64

163

Net Investing Cash Flow

-861.38

-6330

-8370

Cash Dividends Paid - Total

27.12

119.8

229

Issue/(Repurchase) of Common & Preferred Stk.

(235.28)

1010

0

Issuance of long term debt (Reduction)

757.91

5500

9410

Net Financing Cash Flow

966

6380

8680

Free Cash Flow

6

32

-257.36

Dividend Cover By Net Operating Cash Flow

1.22

1.27

0.71

Two Harbors has the highest yield on this list but the company overview quickly highlights the precarious position of the dividend.

The dividend is not wholly covered by earnings on a TTM basis. Furthermore, looking into the cash flows of the business, the dividend is not covered by net operating cash flow.

Net operating cash flow was $163 million during 2012, while the company paid out $229 million in dividends. The dividend was presumably covered by assets sales or debt issuance, indicating the payout is not sustainable.

American Capital Agency Corp. (NASDAQ:AGNC)

Share Price

EPS

Dividend

Yield

Dividend Cover

$32.5

$4.4

$5.0

15.4%

0.9

Cash Flow Statement

$US millions

2010

2011

2012

Net Operating Cash Flow

-20

1,020

1,683

Net Investing Cash Flow

-8,750

-39,260

-14,073

Cash Dividends Paid - Total

173

663

984

Issue/(Repurchase) of Common & Preferred Stk.

1,050

4,380

3,772

Issuance of long term debt (Reduction)

7,910

35,980

925

Net Financing Cash Flow

8,740

39,440

25,736

Free Cash Flow

-30

1,190

699

Dividend Cover By Net Operating Cash Flow

-0.11

1.54

1.71

American Capital Agency looks bad at first sight, as the dividend is still not covered by earnings. However, the cash flows of the company suggest the dividend is more sustainable than at first glance.

The company's high dividend has been well covered from earnings for two years now, indicating the payout is sustainable without having to rely on asset sales and debt re-structuring.

ARMOUR Residential REIT, Inc. (NYSE:ARR)

Share Price

EPS

Dividend

Yield

Dividend Cover

$6.6

$0.9

$1.0

14.7%

0.9

Cash Flow Statement

$US millions

2010

2011

2012

Net Operating Cash Flow

9

118

193

Net Investing Cash Flow

-987

-4,740

-15,560

Cash Dividends Paid - Total

9

87

185

Issue/(Repurchase) of Common & Preferred Stk.

94

561

1,539

Issuance of long term debt (Reduction)

925

4,360

14,480

Net Financing Cash Flow

1,010

4,840

15,840

Free Cash Flow

0

31

8

Dividend Cover By Net Operating Cash Flow

1.03

1.35

1.04

At first glance, ARMOUR follows the trend and is not able to cover its dividend from earnings. Yielding nearly 15%, the company has the third highest yield on this list.

Looking at company cash flows, the dividend does look to be covered although, only just. Over the past three years, ARMOUR has been able to cover its dividend payments by its net operating cash flow - so far it is the only company on this list that has able to cover its dividend payments consistently for the three year period.

CYS Investments Inc (NYSE:CYS)

Share Price

EPS

Dividend

Yield

Dividend Cover

$11.8

$2.7

$1.6

13.6%

1.7

Cash Flow Statement

$US millions

2010

2011

2012

Net Operating Cash Flow

-2,480

-4,520

-7,211

Net Investing Cash Flow

0

0

0

Cash Dividends Paid - Total

77

185

116

Issue/(Repurchase) of Common & Preferred Stk.

488

275

871

Issuance of long term debt (Reduction)

2,070

4,440

6,033

Net Financing Cash Flow

2,480

4,530

7,220

Free Cash Flow

-2,560

-4,700

-7,331

Dividend Cover By Net Operating Cash Flow

-32.21

-24.43

-62.16

CYS is the first company on this list that can cover its dividend payout from its EPS.

However, the company's cash flow is highly erratic. CYS has not seen a positive cash inflow from operations since 2007, yet the company has continued to offer a dividend. It appears the dividend has been paid for through stock issuances, which have totaled approximately $1.6 billion over the past three years. In addition CYS has been issuing debt to try and unsuccessfully bolster its cash flow.

CYS' dividend looks to be secure at first glance but under deeper inspection the yield looks unsustainable.

Hatteras Financial Corp (NYSE:HTS)

Share Price

EPS

Dividend

Yield

Dividend Cover

$26.8

$3.5

$2.8

10.4%

1.3

Cash Flow Statement

$US millions

2010

2011

2012

Net Operating Cash Flow

176

344

312

Net Investing Cash Flow

-2,700

-8,020

-8,511

Cash Dividends Paid - Total

179

255

226

Issue/(Repurchase) of Common & Preferred Stk.

271

860

865

Issuance of long term debt (Reduction)

3,233

7,480

7,394

Net Financing Cash Flow

2,410

7,920

7,995

Free Cash Flow

-113

234

85

Dividend Cover By Net Operating Cash Flow

0.98

1.35

1.38

Hatters offers the smallest yield on the list at 10.4%. The company also appears to have one of the strongest dividend payouts of the group. The dividend is well covered by EPS and net operating cash flow with room to spare.

However, Hatters has been issuing significant amounts of shares over the past three years. That said, the rest of the companies in this article are all doing to same thing, so it appears it is nothing unusual for the sector.

Overall

On the face of it, the majority of these companies are not able to cover their dividends from EPS. However, on a cash flow basis the majority of the payouts appear sustainable.

The dividend that looks to have been the safest for the longest period of time is AMOUR's. On the other hand, the dividend that looks to be most unsafe belongs to CYS Investments.

Source: How Safe Are The High Yields Of Financial REITs?