Why I will never buy Annaly Capital Management

Annaly Capital Management ( NLY -2.25% ) is one of the best-known mortgage real estate investment trusts (mREITs) that investors can buy. And it sports a whopping 13% dividend yield today! Only, there’s more investors need to understand about mREITs than just yield. Here’s why I’ll never buy Annaly and why you should be careful too.

The basic model

Most mortgage REITs purchase pools of mortgages that have been aggregated into a single asset, often referred to as secured mortgage bonds (or CMOs in industry jargon). That, in and of itself, isn’t such a bad thing. These securities pay interest and principal to the owner over time, with the most notable “normal” negative being the risk of prepayments.

Prepayments reduce the principal of the CMO and leave the REIT looking for a place to put that money. The problem here is that prepayments normally occur when rates fall, so capital must be tapped at lower rates. It’s a fairly manageable problem that becomes less of a problem when rates rise, as they do today.

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The other big risk is loan defaults, which was a major headwind during the 2007-2009 housing recession. This is the problem that has puzzled me when I have owned a few mREITs. But the real problem here isn’t the defaults, per se. The problem is more fundamental for the mREIT business model, which involves using leverage to increase the size of a REIT’s CMO portfolio.

Essentially, mREITs like Annaly use the portfolio they own as collateral for the loans they use to buy more CMOs. But CMOs are assets that go up and down in value. So when times get tough, MREITs may face demands for additional capital to back up their loans. It’s like a margin call for an individual investor, and it can lead to massive portfolio upheavals. The big takeaway is that leverage limits financial flexibility, usually when you want that flexibility the most.

Palmares

The biggest risk for dividend investors in all of this is that the quarterly dividend check you collect may not be as safe as you think. For example, Annaly’s dividend yield has been above 10% for most of the past decade. And over this same period, the dividend has fallen by around 60%. Yield and stock price move in opposite directions, so the stock price must fall to keep the yield above 10% while the dividend payment declines. That’s exactly what happened here, with stocks also down almost 60% over this 10-year period.

NLY Chart

NLY data by YCharts.

If you’re looking to create a steady stream of income to live off of in retirement, Annaly is a terrific choice for your wallet. What’s interesting here is that I can’t say Annaly is bad company. For the most part the management is doing a good job. And for the right kind of investor, the stock was a net positive. Specifically, if you reinvest your dividends, the total return here over the past decade is almost 35%.

You would have done much better in a diversified REIT exchange-traded fund (ETF) like Vanguard Real Estate Index ETF. However, with Annaly’s shares down nearly 60% but total return – which includes reinvested dividends – up 35%, you can see it’s not as bad an investment as it looks. appears from the share price alone. Yet this is only true if you are not looking to use those dividends.

NLY Chart

NLY data by YCharts.

And that’s why I will never buy Annaly. I am a dividend investor and one day I intend to start using this dividend stream to pay my daily expenses. This is simply not what Annaly and most other mREITs are designed for.

Know what you own

We all make mistakes when it comes to investing. The key is to learn from them. When I got burned by mREITs during the so-called Great Recession, it was because I didn’t understand the real business model at play, which is not to provide investors with a reliable and growing stream of dividends. Add to that the inherent leverage of the business and you can begin to see why most dividend investors would be better off avoiding mREITs like Annaly.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end consulting service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.