5 REITs To Boost Your Portfolio In An Unstable Market

| About: Annaly Capital (NLY)

The synthetic rate environment championed by Ben Bernanke has left investors scrambling to find yield. Traditional investments such as US treasuries provide negative returns and even the juiciest corporate dividends top out at a meager 5 to 6%. Real Estate Investment Trusts provide a golden opportunity for investors looking to supercharge their portfolios. The REIT structure forces the firm to distribute 90% of its income to investors in the form of dividends, but allows it to bypass corporate income tax. Investors can find dividends yields up to 20%, depending on the aggressiveness of the firm. On the flipside, dividends are not stable and a substantial cut in the payout usually tanks the share price as well.

REIT investment will require changes to your due diligence. Common metrics such as price-to-earnings do not provide a proper valuation of company cash flows. True cash flow is more accurately illustrated by the funds from operation (FFO) metric. The REIT's net income and depreciation are summed to find the FFO. The result is divided by a capitalization rate and the company's debt is subtracted from this total, the net asset value (NAV). The NAV is divided by the firm's outstanding shares and to find the NAV per share. In a perfect world, the NAV per share equals the share price. Determining a REIT's true value is extremely difficult because picking the cap rate is an art form, it represents the yield which a firm must attain to be a worthy investment in your portfolio. The same firm can have different explicit cap rates solely based on the goals and objectives of various portfolios. You might want to break out an investment textbook to help with this one.

I have calculated the implied capitalization rates of the five REITs in this article to illustrate the differences in risk between the firms. A higher cap rate indicates a riskier investment.

The Players

Annaly Capital Management (NLY) is a Manhattan-based REIT that invests in a wide variety of mortgage-backed securities. It invests in mortgage pass-through certificates in which it buys the cash flow from home mortgages, but leaves the banks to service the loan. It also buys collateralized mortgage obligations, known as home mortgage pools in plain English, which are bundles of mortgages sold by banks to investors. Additionally, it purchases agency callable debentures, the unsecured debt of government agencies such as the Tennessee Valley Authority.

The REIT trades for $16 per share and pays a quarterly dividend yielding 14%. Annaly has $107.9 billion in cash and equivalents on and investment-related debt of $87.5 billion on books. Its funds from operations totaled $1.14 billion in 2011, which implied a very low cap rate of 1.1%

Chimera (CIM) is a subsidiary of Annaly. The firm holds a much riskier portfolio than Annaly, including direct investment in residential mortgages, unsecured mortgage-backed securities, and other real estate investment instruments.

It trades for a measly $3 per share, but its dividend yields a hefty 15.90%. It has just $9.8 million in cash compared to over $4.05 billion in investment debt. Chimera's FFO totaled $285 million in 2011 and its cap rate is much higher than Annaly's at 4.1%.

ARMOUR Residential REIT (ARR) buys fixed, adjustable, and hybrid mortgage-backed securities from Fannie Mae, Freddie Mac, and Ginnie Mae. These instruments are secured by the federal government in the case of default.

The share price is just under $7 and its dividend yields 17.50%, the highest of the five companies in this list. It has $400 million in cash and equivalents and just $127 million in investment debt. ARMOUR has funds from operations of $24,365,000 last year. Its cap rate is a very reasonable 2.3%.

American Capital Agency (AGNC) from Bethesda, MD is my least favorite on this list. The company also purchases secured mortgage-backed securities from government sponsored entities (GSEs) such as Fannie and Freddie. The REIT, in my opinion, is overvalued and shareholders can look forward to substantial near-term dividend cuts.

American Capital trades at $30 per share, by far the most expensive on this list, and the yield of its dividend is 16.7%. It has $11.5 million in cash, yet roughly $7.9 billion in investment debt. In 2011, its FFO stood at $1.13 billion with a very high cap rate of 10.81%. The FFO number is similar to Annaly's, but generated from a far smaller pool of assets. American Capital is an excellent example of the cap rate's importance. If American Capital's investments remain profitable, its portfolio will end up far more efficient than Annaly's. However, a small pullback in its return would be catastrophic to the firm and its investors. 11% returns year after year are not, in my opinion, a safe bet in the present economy.

The last firm in the line-up, hailing from Waltham, MA is CYS Investments (CYS). CYS holds a portfolio of federally secured mortgage pass-through certificates.

CYS trades hands at $13 and its dividend yields 15.30%. The REIT has $11.5 million in cash and nearly $7.8 billion in investment debt. CYS had FFO of $345 million in the previous year and its cap rate stands at 3.68%.

The Bottom Line

I must throw a word of caution out there before I recommend any one of these REITs. The fat dividend yields of these firms stem from heavy leverage that enables their business models to turn huge profits. Leverage magnifies both gains and losses, and a few wrong moves could wipe anyone of these firms out in short order. If you need to get a handle on what normal real estate returns look like, check the iShares Dow Jones US Real Estate ETF (IYR) or the Vanguard REIT Index ETF (VNQ). The two ETFs have dividends yielding 3.5 and 3.4%, respectively. A well-diversified portfolio should contain anywhere between 10 and 20% real estate. REITs and real estate ETFs are both low-cost methods of achieving this.

I recommend ARMOUR as the best trade out of the five REITs mentioned here. Notice, I emphasize this as a trade, not an investment. There is no question the Federal Reserve will raise interest rates, rather the question is when that will occur. The dividends of all these REITs will plunge as interest rates rise and spreads tighten, although it seems the party could last as long as 2014.

ARMOUR posted negative net income $9.4 million last year, but had positive cash flows of $217 million. Depreciation is huge when factoring a REIT's true profitability and the net income calculation neglects this figure. ARMOUR's dividend is relatively safe for now and its shares are priced at a reasonable level for its risk-reward trade-off. For a safer REIT play, go with the herd and buy NLY. The trade is a bit less crowded than at this time last year when shares changed hands at $18, but it is still the obvious move. Just be ready to jump out when Operation Twist comes to a close and the proposed QE3 is scrapped.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.