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Mortgage REITs catch investors' attention for their double-digit dividend yield. The largest U.S.-listed mortgage REIT, Annaly Capital Management (NYSE:NLY), yields 13.7%. In addition, Armour Residential (NYSE:ARR) yields 17.7%, American Capital Agency (NASDAQ:AGNC) yields 16.3%, and Hatteras Financial (NYSE:HTS) yields 12.4%.

Mortgage REITs invest and trade in agency- or non-agency-backed mortgages. In case of agency securities, mortgages have to fulfill certain underwriting standards (such as LTV ratios, documentation requirements and maximum loan values) and have behind them the government sponsored entities Freddie Mac and Fannie Mae. In effect, mortgages are backed by the full faith and credit of the U.S. government. Agency securities effectively contain a guarantee that functions as credit enhancement and makes agency-backed securities less risky as principal and interest payments are more certain compared to non-agency securities. Assets in mortgage portfolios are especially hard to understand and analyze given their technical complexities. Mortgage REITs take on short-term debt and invest in longer-term mortgage-backed securities thereby earning money on the net interest spread that results from the difference in yields on their mortgage securities and their financing costs.

Considering the low interest environment over the last years, Annaly and other mortgages REITs found themselves exposed to one of the most favorable investment climates possible for mortgage REITs that is coming to an end: A near-zero interest rate policy that brought massive relief to the financing side of mortgage portfolios, which, in turn, is reflected in highest cyclical distributions. As demonstrated by Annaly, yearly distributions peaked in 2010 and are continually downtrending into the first quarter of 2012.

Over the long-term, investors can expect to earn a return on equities of around 8%-9%. Without being active, without the need to adjust portfolio positions, incurring transaction costs and simply holding on to stocks such as Annaly, it is easy to understand the attraction that investors feel for these high-yielding REITS. My readers know that I am a big believer in the contribution of dividend yields to overall returns, especially considering my intention to earn more than the long-term average. By just sitting back, you can pocket 14% or more. But how about dividend sustainability and the effect of the next interest rate cycle on distributions and the corresponding yield?

Sustainability with payout ratio of more than 100%?

Doubtful. Annaly exhibits a payout ratio of roughly 124%, Armour Residential is even worse with a payout ratio of over 130%, and Chimera exhibits 116%. Even though REITs are obligated to distribute at least 90% of their earnings, paying out more than you earn is not sustainable. Eventually, the market will price this in more realistically.

Where are we in the interest rate cycle?

Once the market perceives interest hikes by the central bank to be more credible, resulting higher expected financing costs and reductions in the net interest spread will put downward pressure on mortgage REITs as earnings and dividends naturally decline (assuming no debt financed distributions to common stockholders). With high unemployment, large federal deficits to stimulate the economy and lowest interest rates, all an investor can reasonably expect going forward is the manifestation of an expansionary phase with the corresponding interest rate hikes. However, the anchoring of expected interest rate increases in the minds of investors is likely to bring increased focus on mortgage REIT's financing costs and reduced earnings sooner than later. As a result, mortgage REIT investors should expect to face continued decreasing distributions over the interest rate cycle as well as decreasing stock prices. Only lower stock prices will be able to offer investors the required risk-adjusted returns to invest in highly leveraged mortgage REITs.

I do not intend to discount the dividend yields that Annaly and others offer in the REIT space. I'd rather like to compare the high yields to buying common stocks at their cyclical highs. Given the track record of being able to profitably manage a mortgage portfolio, Annaly would probably the best choice to go for, if you are comfortable with the risks you are accepting. My prediction is that share prices and distributions are going to go down materially over the next two to three years, cutting yields in half.

Source: Annaly And Other mREITs: Lower Dividends And Stock Prices To Come