Are Mortgage REIT Dividends Free Money?

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I've written in the past about the risks associated with mortgage real estate investment trusts Annaly Capital Management (NYS: NLY) and American Capital Agency (NAS: AGNC) , and I've become increasingly disturbed by reader comments that make it clear that some shareholders believe mREIT dividends are "free money." As a result, I think it's crucial to dispel a few fundamental misunderstandings about these companies and their stocks.

This is no straw man
If you are among the mREIT shareholders who have a solid grasp on the risks inherent in these shares, you may think this "free money" attitude is purely a straw man position that I have created. To prove that isn't the case, just take a gander at the following comments, which I lifted verbatim from one of the most highly rated bullish CAPS pitches for Annaly Capital: "By ensuring [Fannie and Freddie's] survival, the government ensures that Annaly Capital Management won't go belly up as well. So basically we have an almost guaranteed yield in double digits every year, unless the stock price skyrockets, which wouldn't be bad at all."

I rest my case for the utility of an article like this one.

First reality: There are no barriers to entry in this business
You might think mREITs have a defensible franchise. After all, not just anyone can manage a large portfolio of mortgage securities. Well, yes and no. Yes, managing a mortgage bond portfolio requires knowledge and experience. However, any reasonably established trader fresh off a Wall Street mortgage desk can launch a hedge fund and go head-to-head with Annaly in a matter of months; all you need is some office space, a Bloomberg, and a few signed documents with a prime broker.

Strictly speaking, it's not entirely true that there are no sources of competitive advantage in this area. In theory, a strict value discipline and the ability to adopt a long-term time horizon are the twin pillars of success. I'm willing to believe that Annaly's management has a value orientation (although I think Redwood Trust (NYS: RWT) is a better example of this than either Annaly or American Capital). The trouble is that mREITs lack financial flexibility because they must, by law, pay out 90% of their profits to shareholders, and they depend heavily on short-term financing. That's a huge structural impediment to implementing a value approach -- particularly during periods in which it would be most profitable.

Second reality: Businesses with no moats don't earn excess returns
It's a basic principle of finance: If you have no competitive advantage, you cannot expect to earn excess returns over an extended period of time. Does that mean mREITs have a competitive advantage? Take Annaly, for example, which has delivered an 11.3% annualized return over the past 10 years, smashing the S&P 500's 3.4% return in the process.

Occam's razor suggests to me a simpler, more consistent explanation: mREIT stocks are much riskier than the average equity. Here's another way to think about it: Which of the following two propositions is more likely?

  1. MREIT shareholders have spotted an extraordinary opportunity to earn a low-risk 14-percentage-point yield premium over the 10-year Treasury bond rate (in the case of American Capital). The rest of the market has completely misunderstood the risk/reward proposition these shares represent.
  2. In exchange for pocketing 14 percentage points in yield premium over the risk-free return, mREIT shareholders are bearing substantial risk.

I'm going to go with No. 2 for $2,000, Bob.

Third reality: I'm not against mREITs
I've seen them before, so I fully expect to see multiple comments in the section below accusing me of using scare tactics to keep people out of mREITs. Let me make this clear: I have no emotional or financial interest related to mREITs, and I am perfectly happy for people who invest in them, if that is their wish. However, I believe investors are better off when they understand the risks of their investments. Incidentally, everything I have written here applies equally to mREITs that don't invest exclusively in agency mortgage securities, including Invesco Mortgage Capital (NYS: IVR) and Chimera Investment (NYS: CIM) .

What you need to do now
I don't wish mREIT shareholders any harm -- that's the reason I'm writing this article. However, I fear that a significant proportion of them are "walking around blind without a cane," to quote the infamous Gordon Gekko. I know it's considered quaint nowadays for an investor to read a company's annual report, but if you own mREIT shares (or are considering buying some) and you haven't already done so, I strongly urge you to review the "Risk Factors" section of these companies' most recent 10-K reports. That is the first step you must take if you want to understand what could go wrong with your investment.

If you want to collect dividends that are truly low-risk, get The Motley Fool's free report explaining how to "Secure Your Future With 11 Rock-Solid Dividend Stocks."

At the time this article was published Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Annaly Capital Management. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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