5 REITs: Great Yields, Even Greater Uncertainty

by: Dividend Kings

In an unprecedented long term low interest rate environment, achieving a decent rate of return on investments demands a step up in risk. Real Estate Investment Trusts fit the bill for attractive high yields, some in double digit territory, but the constant nag of high leverage and the threat of any rise in interest rates create an element of risk not to be ignored.

The quality of the security instruments underlying REITs is a key factor in assessing the effect a change in interest rates might have on the investment. For mortgage back REITs, their income depends on borrowing at low or no interest rates then collecting the higher interest generated from its holdings of long term mortgage debt. The difference between the borrowing rate and the collecting rate is the spread. A rise in interest rates increases borrowing costs, reducing the profits from the spread and lowering the amount of capital available for dividend payouts. A lower dividend yield causes holders to flee the REIT sending its share prices lower.

Some of the best yields today are from mortgage backed or mREITs. Yields above 12% are common. Share prices are off 52 week highs in concert with the broader financial sector’s swoon, reflecting the uncertain climate in worldwide capital markets.

Annaly Capital Management (NYSE:NLY) is trading in the middle of its 52 week range at almost par with its book value of $16.22. The company’s market cap is $15.74 billion with 40% held by institutions. NLY holdings primarily include agency (government backed with an implicit guarantee) mortgage securities and mortgage backed instruments which helps moderate risk for a healthy yield of 14.20%.

Chimera Investment Corporation (NYSE:CIM) holds primarily diversified residential mortgage backed and asset backed securities, including jumbo and alt a loans. Third quarter 2011 saw a 43% drop in income due to declining returns on investments which offset its interest gains. The current dividend yield is at 16.1%.

Armour Residential REIT, Inc.(NYSE:ARR) trades around $7 and has holdings that are predominately agency backed adjustable rate mortgage securities. Though it has maintained a great dividend return of 19%, it has experienced falling earnings per share and negative returns on equities and assets in the recently completed quarter.

MFA Financial, Inc. (NYSE:MFA) also trades near $7 with a portfolio of hybrid and adjustable rate mortgage backed securities. With a p/e ratio of 7.35 and earnings per share near $1, its yield is running at 13.

American Capital Agency Corp (NASDAQ:AGNC) holds agency backed pass through mortgage securities. Earnings have grown 300% year over year for a low p/e under 5 and a yield over 18. t

Apollo Investment Corporation (NASDAQ:AINV) is more of a BDC (business development company) REIT than a mortgage REIT. It operates as a closed end management investment company. While it may invest in mortgage securities, its primary focus is investment in a diverse range of middle market companies. Typically investing between $21 to $250 million, AINV seeks a five to ten year maturity horizon. Currently trading near its 52 week lows around $7 with third quarter 2011 misses in both return on equity and profit margin.

Any rise in short term borrowing costs will pressure these REITs due to the amount of leverage required to sustain high yields, however based on recent actions by the Federal Reserve, interest rates look to remain low until strength in US economy is sustained. Look for falling unemployment numbers and consistent increases in GDP before the Fed incrementally begins to bump up rates.

Non risk averse investors have a continuing opportunity to realize high yields from well managed REITS as long as the US economy drifts, but must understand that constant due diligence on the quality of the mREIT portfolio (with government agency backed securities lowering risk) and its leverage composition is essential.

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