5 REITs To Supplement Your Income

Includes: AGNC, ARR, CIM, CYS, NLY
by: Stock Croc

Mortgage lenders are not exactly flinging the red carpet out and begging for new loans, but as delinquencies and defaults begin to falter, there is some optimism on the horizon.

In April, Lender Processing Services issued a report that seemed very upbeat. Foreclosure filings were down 15% in February. Total U.S. loan delinquency rates were hovering at just under 8%. Florida, Massachusetts, Nevada, New Jersey and Illinois still clung on as the states with the highest defaults.

Many homeowners, however, still feel the squeeze of a house not worth the loan amount of their mortgage. There is still concern that many homeowners will continue to resolve themselves to a strategic default where they simply throw their hands up and walk away from a home they may never be able to pay for. Strategic defaults are often the last resort a homeowner will utilize when they feel their lender is not listening or responding with an alternative such as a loan modification.

Regardless of what the market may be doing, a Real Estate Investment Trust (REIT) has been a positive alternative. Traditionally REITs have outperformed the market as a whole paying out large dividends. The National Association of Real Estate Investment Trusts reported REITs returned roughly four times that of the overall stock market in 2011.

Maintaining your investment in a REIT that rewards you with generous dividends has the huge potential upside of a steady income without having to divest yourself of a position. There is also more financial flexibility, a greater hedge against inflation, and cash flow regardless of the markets movement. Compounding escalates, and there is the potential source of two incomes through your capital gains and dividends.

REITs pay 90% of their taxable income to shareholders in the form of dividends according to law. In 2011, most REITs were confident and issued dividend payouts in excess of their 2010 level of $18 billion. That same optimism appears to be holding in 2012.

Armour (NYSE:ARR), headquartered in Vero Beach, Florida, invests primarily in residential mortgage-backed securities issued or guaranteed by the United States government such as Fannie Mae, Freddie Mac or Ginnie Mae. It differs from most of its competition. Armour purchases all three types of mortgages, fixed, adjustable, and hybrid-rate securities. Adjustable rates and hybrids make up 20.1% of its asset portfolio.

In early March, Armour announced that it would undertake a 30 million share underwritten public offering of common stock. Deutsche Bank and Bank of America Merrill Lynch are acting as joint book-running managers for the offering. Armour intends to utilize the infusion of cash to acquire additional securities as the market shifts.

Armour's share count is dramatically rising from 7 million shares 18 months ago to 85 million today. Some analysts are concerned that Armour will remain a high-yield stock on paper (with its dividend yield of 18%) but that the dilution of the share base could dissolve the current high dividend. It may be difficult to maintain in the end.

Falling interest rates may affect REIT returns if the rates for new refinanced mortgages continue to remain low. This could create a difficult situation for sustaining income. Armour has about a $600 million market cap, generating revenues of $12.18 million.

The rise in interest rates will adversely affect highly-leveraged REITs. Currently, Annaly (NYSE:NLY) has a leverage ratio of 5.4 and Armour is at 8.52, well within the safe zone. While Armour has a slightly higher leveraged ratio, it has switched up its interest rate hedging strategy putting itself in a better position to weather any interest rate hikes. As far as mortgage REITs go, Armour uses considerable leverage, but finances safe, lower-yielding investments. While the income is lower, the assets are safer.

Armour maintains an "investor-friendly" dividend history, which is inviting. The current dividend yield of 18% is almost three times the average overall yield of shares in the REIT sector of 5.5%. Several analysts feel Armour is in a strong position to sustain these high dividend yields.

Other REITs are also offering double digit dividend returns. Annaly is posting almost a 14% dividend yield. Chimera (NYSE:CIM), a subsidiary of Annaly, pays out a 15.90% dividend. CYS Investments (NYSE:CYS) also hands out a double digit return of 15.30%.

On the flip side, other analysts see the positive double-digit returns as fading. Some analysts site Armour's dividend drop to $0.10 from $0.11, American Capital Agency's (NASDAQ:AGNC) $1.40 to $1.25 and Annaly's drop of $0.02 to $.055 to be ominous signs. Still, even if these REITs drop into single digits, all three are still outperforming their competitors, and investors will still see positive returns on their investments. I do not, however, see this as an inevitable outcome.

REITs are an attractive buy compared to fixed income markets. The sector is delivering an above-average dividend and has a good growth outlook. There is a 10% annual REIT dividend growth expected per year for the next several years. In the second quarter of 2012 Armour is reporting a 2012 monthly cash dividend rate of $0.10 per Common Stock share, translating to a solid double-digit dividend.

With such a large yield, safe investment leverage and economic conditions at the moment favoring REITs, time is on Armour's side. The dividend wave will most likely crest in the future, and the swell will not be as large but the surfing for now is very good and the high dividend wave should remain consistent for the near to medium future.

The past few years investors have moved money to REITs in response to the Fed's interest rate policy. This may be an excellent time to add to your REIT positions. It is doubtful the Fed will raise rates anytime soon.

Average earnings estimates expect Armour's earnings per share to quadruple by December 2013. Sound performance and impressive growth in the last financial year allow Armour to increase cash flow and stretch revenue and growth margins. I believe the stock has great potential to meet estimates and surpass its target-trading price of $7.30. The current dividend yield of almost 18% makes Armour one of the strongest REITs.

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