Annaly Capital Management's Total Return Won't Pay the Bills

Annaly Capital Management is a REIT with an astonishing yield, but you need to understand what you’re buying, or you could get burned.

The most attractive feature of real estate investment trust (REIT) Annaly Capital Management (NLY 1.47%) is its humongous 13.7% dividend yield. That’s why most investors will want to buy it, given that the average yield on the S&P 500 Index is about 1.3% and the average REIT is yielding only about 4%, using Vanguard Real Estate ETF (VNQ 0.67%) as a proxy.

But before you get too caught up in the high yield here, you need to understand that the Annaly story is really about total return.

What does Annaly Capital do?

While Annaly is a REIT, it isn’t a landlord. It’s fairly easy to understand what property owning REITs do: They buy physical assets and lease them out to tenants. That’s what you’d do if you had a rental property. But Annaly is a mortgage REIT, which means it buys mortgage loans that have been pooled into bond-like securities. Its revenue comes from the interest it collects on these bond-like securities, often called something like a collateralized mortgage obligation.

A scale showing risk from low to high with the pointer on the dial on high.

Image source: Getty Images.

For starters, that’s more like a mutual fund model than a typical REIT model, given that there are no operating assets involved. Annaly’s value is effectively based on its portfolio of mortgage securities. But that’s not the only difference you need to understand, because the mortgage market is fairly complex. Interest rate changes can affect mortgage demand, mortgage availability, mortgage repayment rates, the housing market overall, and the value of the mortgage securities that companies like Annaly own. Add in the use of leverage, often backed by the mortgage securities in the portfolio, and all of the risks at play here can get amplified during rough times.

So before you even look at the massive dividend yield on offer, you need to make sure you’re willing to do the legwork to understand what you’re buying. Most investors would be better off sticking with an easier-to-understand property-owning REIT, even though the yields won’t be as high.

Annaly is a total return investment

The biggest problem with Annaly comes as investors look at the 13%-plus yield and think of it as a dividend investment. That’s just not the case here, because Annaly is actually a total return investment. Before the dividend yield even shows up on the company’s investor relations website, management points out that the stock’s total return since its initial public offering is 790%. In fact, of the five reasons listed under “Why Invest in Annaly,” dividend yield isn’t even mentioned. What’s going on?

For starters, total return assumes the reinvestment of dividends. That’s a great investment strategy, but a large percentage of dividend investors are going to want to live off their dividends, using them to support their day-to-day spending needs. What would the return look like if an Annaly investor didn’t reinvest the dividends? Well, as the following chart shows, the story would be pretty bleak, with such investors suffering more than a 50% loss of capital.

NLY Chart

NLY data by YCharts

But don’t stop there. Look at the orange line, which is the dividends paid per share. That line is hugely volatile, and it has been falling steadily for about a decade or so. Thus, not only did investors who used their dividends end up with less capital, but they ended up with less income, too. That’s about as bad as it could get for a dividend investor.

You have to look past Annaly’s yield

In all, if you don’t reinvest Annaly’s dividends, which would be focusing on total return over income, history suggests that you’re likely to end up very disappointed with an investment here. That’s not to say Annaly is a bad mortgage REIT. It’s pretty openly telling shareholders what they should be focusing on: total return. It just isn’t appropriate for investors looking to live off the dividend income their portfolios generate.

Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Specialized Funds-Vanguard Real Estate ETF. The Motley Fool has a disclosure policy.

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