Is Armour Residential A Danger To Your Portfolio?

| About: ARMOUR Residential (ARR)

Seeing the 16%+ dividend yield of ARMOUR Residential REIT (NYSE:ARR) will certainly have most investors, especially those who need income, stopping in their tracks. But, what's the catch, and is the catch potentially risky to the health of your portfolio?

What is ARMOUR Residential REIT?

As its name implies, ARMOUR Residential REIT is a real estate investment trust (REIT) that must distribute at least 90% of its earnings in the form of dividends. But unlike most other REITs which focus on investing in physical real estate in order to generate income for investors, ARMOUR Residential REIT invests in hybrid adjustable rate, adjustable rate and fixed rate residential mortgage-backed securities that are issued by government agencies or sponsored entities like Fannie Mae, Freddie Mac and Ginnie Mae.

I should mention that ARMOUR Residential REIT has plenty of company in the mortgage REIT industry with Annaly Capital Management (NYSE:NLY) being one of the biggest industry players with a market cap of nearly $17 billion and a 13% dividend yield. Annaly Capital Management also has two mortgage REIT subsidiaries, Chimera Investment (NYSE:CIM) which currently has a dividend yield of around 15.5% and Crexus Investment (NYSE:CXS) which has a dividend yield of around 11%.

In addition, investors might want to take a closer look at American Capital Agency (NASDAQ:AGNC) whose yield approaches 15%, CYS Investments (NYSE:CYS) which has a yield over 14%, Hatteras Financial (NYSE:HTS) which has a yield of about 12.5%, MFA Financial (NYSE:MFA) whose yield approaches 12% and Two Harbors Investment (NYSE:TWO) with a yield of about 14.5%. Besides having double digit yields, all of the above mortgage REITs (except for Crexus Investment) would have market caps of at least $1 billion - meaning they are not small players in the industry.

Why Mortgage REITs Have Such High Yields (and the Risks Involved)

Income starved investors are naturally going to be drawn toward any investment that promises a double digit yield but it's also important to understand the risks involved with investments in mortgage REITs. Specifically, mortgage REITs operate by generating income off the spread between the interest they receive on mortgages and the borrowing costs to purchase those mortgages. In addition, mortgage REITs will often increase their returns though the use of leverage by borrowing at lower short-term rates in order to lend long.

Naturally there are risks associated with trying to profit from spreads and using leverage with the primary risk in the medium term being rising interest rates impacting profits and hence dividends. But, my guess is that interest rates will remain at near zero until at least 2014 and there will be plenty of warning before they start to rise.

Nevertheless, the other major risk associated with mortgage REITs would be rising conditional prepayment rate (CPR) which is the percentage of principal that is prepaid over a period of time and on an annualized basis. Rising conditional prepayment rates will mean that the mortgage REITs will need to reinvest in new mortgages that are paying a lower rate. Eventually, that will also mean lower dividends for investors.

Does ARMOUR Residential REIT Look Like a Winner?

As of late August, ARMOUR Residential REIT's shares were down nearly 9% since January 2011 and flat over the past year according to Google Finance data but that 16%+ dividend yield is certainly a game changer plus the dividend is paid monthly.

But, a quick look at ARMOUR Residential REIT's dividend payment history reveals monthly dividends of $0.12 from January to September 2011, dividends of $0.11 from October 2011 until March 2012 and dividends of $0.10 from April until the present time. Obviously that's a downward trend but then again, having a 16%+ dividend yield also means that dividend payments would need to fall more than 40% to reach a single digit yield and even then it would still be paying a high single digit yield.

Investors also need to be aware that there will be a key management change at ARMOUR Residential REIT as of September 1 as current CFO Jeff Zimmer is stepping down to be replaced by James Mountain - an industry professional practice director for Deloitte who has over 25 years of experience on securitization transactions. It's still unclear whether there will be an change in ARMOUR Residential REIT's business strategy as a result of this change but it is being seen as a positive.

Finally and in early August, ARMOUR Residential REIT announced the pricing of a 55,000,000 share offering of common stock that will be used to acquire more agency securities as market conditions warrant. A quick search of ARMOUR Residential REIT's old press releases reveals a 40,000,000 common stock offering in July 2012, a preferred stock offering back in May as well as a 31,000,000 share common stock offering, a 26,000,000 share common stock offering in February and a 9,000,000 share common stock offering in January.

So what's with all of these stock offerings? On the one hand and if ARMOUR Residential REIT puts the money to good use, it along with shareholders will eventually come out as winners. But, all of these share offerings seem to be holding back the stock's share price - making dividends and the ability to pay them all the more critical for investors. Likewise (if it matters) and with the share offerings holding down the stock price, it also means that on the tax front, ARMOUR Residential REIT's return is coming from income - meaning investors who don't hold the stock in a retirement account will have to pay taxes upfront rather than wait until a capital gain or loss is incurred when they sell. Hence and while I am by no means a tax expert, it would seem that ARMOUR Residential REIT is not the most tax friendly investment out there.

The Final Verdict: ARMOUR Residential REIT

Mortgage REITs do deserve a small allocation in the portfolios of investors who need steady monthly income - so long as those investors remember that this income could be subject to serious fluctuations and there are risks involved.

As for ARMOUR Residential REIT, investors should be keen to take a closer look but they will need to be aware that its share price is unlikely to produce capital gains that can be deferred for tax purposes so long as the stock keeps having those secondary offerings. Moreover, a 16% dividend yield cannot last forever but that also means it could fall by a considerable amount and sill produce more income than most other investments out there. Hence and for income hungry investors who can live with the above uncertainties or risks, ARMOUR Residential REIT does offer a compelling proposition.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.