Mortgage REIT vs Equity REIT Dividends

Published Tue, 27 Nov 2014 23:30 CET by

Investors' portfolios have witnessed a paradigm shift in variables. The conventional investment instruments such as bank deposits, Certificate of Deposits (CDs) and bonds have been replaced with high paying dividend instruments. Of-late REIT instruments have seen a lot of traction of investors. This is solely because of the improving housing market that has lifted investor sentiment to a new high. The dividend yields of a couple of REITs are in the double digits. Seeing such a performance, it is quite natural for an investor to get attracted towards such an instrument, especially considering the fact that the interest rates are at record low of 1%.

Mortgage REITs versus equity REITs
REITs can be divided in two segments: equity and mortgage. Companies that fall in the mortgage REITs category are very interest rate sensitive. Equity REITs, unlike the mortgage REITs, are less sensitive to interest rates. Mortgage REITs earn profits based on the differences between interest rates, while equity REITs develop, purchase and sell commercial and residential properties. When an interest rate rises, it directly affects mortgage REITs but it does not necessarily affect equity REITs. Over time, the value of equity REITs can defy the interest rate changes.
With high yield comes equal and parallel volatility and risk. Two mortgage REITs with double digit dividend yields are Annaly Capital Management (NYSE: NLY) and American Capital Agency (Nasdaq: AGNC). The current dividend yields are 10.4% and 11.5%, respectively. Two interesting equity REITs are EPR Properties (NYSE: EPR) and Hospitality Properties Trust (NYSE: HPT). The dividend yields of these two REITs are 5.1% and 6.4%, respectively.

Interest-Rate Risk
The United States' economy is advancing beyond the Street's expectations. The unemployment rate has reduced drastically within a year and the inflation rate is also increasing gradually. The impressive economic indicators have forced the lawmakers to consider an interest rate hike. Because of the consequences the sector might face due to increasing interest rates, major investors are reluctant to invest more money in the REIT sector. Increasing interest rates tend to increase the financial costs, which might influence the sustainability of the dividend pay-out.

Mortgage REITs
A company such as Annaly Capital Management, which mints profits from buying and selling mortgage-backed instruments, is highly vulnerable to interest rate changes. Basically, Annaly purchases mortgage-backed securities for 15-year maturity periods at a 3.5% interest rate. These purchases are funded by taking short-term loans at 2% interest rates, thus making a profit between the interest rates. Any increase in the interest rates will prompt the short-term borrowing rates to increase, thus reducing the profit margin for the company. Reduction in profitability will directly affect the dividend pay-out which will reduce the dividend yield. Additionally, the Earnings per Share (EPS) and Return on Equity (ROE) of the company are highly unstable. The EPS of the company has been reduced to USD 0.35, compared to USD 1.05 recorded nine months ago. Considering the company's vulnerability to the interest rates, it is risky to consider Annaly as a long-term investment.

American Capital Agency offers a mixed set of financial numbers, which makes it an ideal stock to avoid. The dividend pay-out of the company is quite stable. However, the EPS of the company raises questions about the company's profitability. Month over month EPS of the company has been in the positive territory since the past two quarters, while on a year over year basis, the EPS of the company has been in a declining mode. The EPS of the company has declined from USD 6.78/share in 2009 to USD 3.28/share in 2013. During the same period, the revenue of the company has increased nearly 20 times from USD 128 million in 2009 to USD 2193 million in 2013. This affirms the fact that the profitability of the company is sceptical. The share price of the company has lost a quarter of its value in the last year. However, the share price has appreciated nearly 29% on a 5-year average basis. The company, like Annaly, is concerned over the possibility of rising interest rates which might affect the company's profitability. In order to safeguard itself from the rising interest rates, American Capital Agency has shifted its focus from long-term (30 years) mortgage loans to short-term (15 years) mortgage loans.

Annaly Capital Management and American Capital Agency REIT Price Graph
Equity REITs
Although the dividend yield of EPR Properties Trust is lower than that of the two mortgage REITs, the company is fundamentally strong. The financials of the company are robust. The ROE of EPR Properties is 163% on a 10-year basis, while on a YTD basis it is 9%. In the last 5 years, the EPS of the company have improved from USD -0.60/share to USD 3.24/share. The net income of EPR rose multi-fold from USD 8 million in 2009 to USD 180 million in 2013. Recently, the company announced a dividend of USD 0.285/share (USD 3.42 on an annualized basis), up 8.2% year over year. The company increased its dividend pay-out for the fifth consecutive year.

Hospitality Properties Trust is perhaps more stable than EPR Properties. Like EPR, the dividend yield of HPT is lower than the dividend yields of NLY and AGNC. ROE over the past 5 years stood at 82%, while on a YTD basis it is 4%. The net income of HPT has improved from USD 21 million in 2010 to USD 133 million in 2013. The EPS of the company increased from USD -0.07 to USD 0.73. However, during the same period, the revenue of the company has not witnessed such a growth, suggesting an improvement in margins.

What an investor should pay attention to while investing in REIT stocks, is whether or not the company is fundamentally strong. Fundamentals of the company are usually known by parameters such as Return on Equity, Earnings per Share and Net income growth. Dividend yields should be considered, no doubt, but it should not be the sole parameter to be considered for investment. The REITs above show that despite a high dividend yield, companies can be fundamentally weak, and vice versa.

Stock name Dividend Yield
American Capital Agency 12.21
Annaly Capital Management 11.70
Hospitality Properties Trust 7.80
Epr Properties 6.03

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