Which Of These 3 REITs Will Outperform In 2012?

Includes: CMO, MFA, NLY
by: Dividend Kings

Real Estate Investment Trusts, or REITs, can be excellent holdings to add to your profile. Gone are the days of calling these passive investments; government regulations require that they pay out the vast majority of their earnings to investors, meaning that these firms are usually great dividend stocks to have. Today, we'll examine Annaly Capital Management (NLY) and try to decide whether we should be owning or selling shares in this company.

Is Bigger Always Better?

Size doesn't matter. At least it doesn't when trying to decide which company is performing better. Annaly Capital Management is a $16 billion giant, while Capstead Mortgage (CMO) sits at $1.2 billion and MFA Financial (MFA) at $2.6 billion. For the most part, investors should be more concerned about the profits each company produces, not its market cap.

Annaly is a company that is growing ($17 target estimate represents a 3% increase), pays great dividends ($2.28 for a 13.8% yield) and is undervalued (price to book of 1.04). Those numbers are all very appealing, especially that huge yield. The problem is that the underlying numbers paint a very different picture.

Annaly has used leveraged investing to strengthen its financial position. Purchasing properties that it intends to use for commercial rentals has allowed the company to profit on the low mortgage rates with higher securities, sometimes getting a 100% return in the process. This changed in 2011, driving up the corporate obligations, as evidenced by its debt to equity ratio of 557.

Over the same period of time, incoming funds collapsed as well, with quarterly revenue falling off by almost 59% and earnings plummeting over 63%, while share prices fell 8%. While the share price drop is not drastic, it is a concern, because the 8% represented a per share drop of nearly $1.5. That amount, if deducted from the dividend, leaves the adjusted yield somewhere around 4%. This is not a very exciting number, by anyone's standards.

Other numbers point to the company's struggles as well. Annaly's price to earnings is an oppressive 45, disconcertingly high for a company that needs to generate more revenue. In addition, its payout ratio is an obscene 655%, strongly indicating that its precious dividends should be reduced.

What about the Competition?

While Annaly struggles, many of its competitors reported success over the same period. Capstead Mortgage enjoyed positive growth in 2011, recording gains in share price (up 2%), quarterly revenue (24.1%) and year-to-year earnings (27.1%). Beyond last year's numbers, the forward outlook for the company is good. Capstead has a low price to earnings ratio of 8.26 and a price to book of just 1.05. The combination of these numbers indicates to me that even though it only has a targeted growth of 3% for the year, it has the potential to go much higher. When you add in its $1.72 annual dividend and its 13% yield, I think this is a solid investment.

MFA Financial is another REIT that has caught my attention. Although its price per share dropped 13% over the past 12 months, I see indications in its forward price to earnings (a low 7.9) and its price to book ratio (a very nice 1.05) that this stock is undervalued and primed to hit the 8% target growth in the next 12 months. Like Capstead, MFA has a much better return on equity (over 13% for both companies) than Annaly's 2.6%.

Although I like both MFA Financial and Capstead Mortgage, neither of these companies is perfect. Both companies have high debt to equity ratios (MFA at 365 and Capstead at 888), and both are over 100% for their payout ratio. That said, I like the growth potential and monster dividend yields that each company possesses.

One Final Positive

As the United States government continues to nurse the economy back to health, it is inadvertently giving a big boost to the REITs. Ben Bernanke's announcement that the Fed will suppress interest rates for the next two years is a godsend for these companies. With leveraging playing an important part in the current business model for REITs, the promise of low interest rates gives these businesses sufficient time to stabilize before they are forced to abandon their practice of leveraging their investments.

Another potential governmental move that could help revolves around the glut of foreclosed homes on the real estate market. The decision to find a way to turn these into commercial rental properties could be a source of new income for REITs, offering a boost to their bottom lines.

Which REIT is Right for You?

While we haven't exhausted all of the necessary research for these companies, we can make a decision on which company offers the best potential. Although I like Annaly Capital Management for a long-term investment, I don't like it short-term. Most of the financials are currently stacked against it, and a hefty decline in share price could eat up most, or all, of its dividend. I believe that as the real estate market continues to level out, demand will turn the company back in a positive direction.

I do like both MFA Financial and Capstead Mortgage, and I think the potential in both is high. There are subtle differences, but the thing that stands out for me is leverage. Capstead has an extremely high leverage ratio; although the Fed doesn't plan to raise interest rates, Congressional efforts to enact financial reforms could hit the company harder. For me, this distinction gives the advantage to MFA Financial, and I recommend it from these three as the best investment at the current time.

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