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REITs are required to distribute at least 90% of their taxable income to their shareholders. They are thus great candidates for the portfolios of income-oriented investors. In this article, we will discuss the prospects of three high-dividend REITs, which are currently offering double-digit dividend yields.

Annaly Capital Management (NLY)

Annaly Capital Management is a diversified capital manager which engages in the investment and financing of residential and commercial assets. The trust invests in various types of agency mortgage-backed securities, non-agency residential mortgage assets, and residential mortgage loans.

Annaly borrows funds from the repo market and invests in agency mortgage-backed securities. It thus profits from the spread between the long-term interest rate of its investments and its short-term borrowing rate.

Annaly has always been extremely shareholder-friendly and has offered exceptionally high dividend yields to its shareholders. Although the company has reduced its dividend by 25% in total in the last three years, it is currently offering an eye-opening dividend yield of 11.2%. Its payout ratio is reasonable for a REIT, at 79%, while its leverage ratio (Net Debt to EBITDA) stands at 4.4, which is in line with the norm in the REIT sector.

However, Annaly is extremely sensitive to changes in interest rates. When short-term rates increase, they exert pressure on the interest margins of Annaly. As a result, the aggressive stance of the Fed, which has pledged to raise interest rates at a fast pace in the upcoming quarters, provides a strong headwind to the performance of Annaly. Overall, while Annaly offers an above-average dividend yield, its dividend may be slashed in the near future due to higher interest rates. In addition, its stock price may come under pressure in an environment of rising interest rates.

Two Harbors Investment (TWO)

Two Harbors Investment is a residential mortgage real estate investment trust (mREIT). It thus focuses on residential mortgage-backed securities, residential mortgage loans, mortgage servicing rights and commercial real estate. The trust generates nearly all its revenues in the form of interest through available-for-sale securities.

Two Harbors is currently facing adverse economic conditions. Inflation has surged to multi-year highs in recent months due to the unprecedented fiscal packages offered by the government in response to the pandemic. However, the curve of interest rates has flattened. Consequently, current coupon spreads have dipped into negative territory, thus indicating low potential for returns from the REIT.

Two Harbors has also been hurt by the coronavirus crisis. To be sure, the REIT cut its dividend by 65% in 2020 and its stock price is 63% lower than its pre-pandemic level. Moreover, just like Annaly, Two Harbors will be negatively affected by the hikes of interest rates expected by the Fed in the upcoming quarters, as higher interest rates will increase its borrowing rates and thus they will hurt its margins.

Despite the 65% dividend cut in 2020, Two Harbors is currently offering an 11.9% dividend yield. However, it has a markedly high payout ratio of 93%. In addition, while the REIT has reduced its leverage ratio (net debt to EBITDA) from 7.7 in 2020 to 6.5 now, its current leverage ratio remains excessive. The REIT also has a debt-to-equity ratio of 6.5, which is far above our comfort zone. Overall, Two Harbors is offering an enticing dividend yield but its dividend does not have a meaningful margin of safety.

ARMOUR Residential REIT (ARR)

ARMOUR Residential is a mortgage REIT that was formed in 2008. The trust invests primarily in residential mortgage-backed securities that are guaranteed or issued by a U.S. government entity, such as Fannie Mae and Freddie Mac.

ARMOUR tries to create shareholder value by taking advantage of the spread between long-term and short-term interest rates. In addition, in order to protect itself from unfavorable trends in interest rates, it hedges its portfolio. Unfortunately, this is much easier said than done. Due to its high leverage, the trust incurs devastating losses during adverse economic periods. Investors should also be aware that the REIT charges an approximate 1% annual management fee to its shareholders regardless of its underlying business performance.

ARMOUR cut its dividend by 54% in 2020 due to the pandemic but it is still offering an exceptionally high dividend yield of 12.9%. However, its payout ratio is unsustainable at 125% while its leverage ratio stands at 6.7 and its debt-to-equity ratio is 3.0. These metrics clearly indicate that the dividend is not sustainable.

On the bright side, even if ARMOUR cuts its dividend by 50%, it will still be offering an above-average dividend yield of 6.5%. On the other hand, the REIT is vulnerable to the upcoming hikes of interest rates expected by the Fed. It is also important to note that ARMOUR has seen its earnings per share plunge 92% and its stock price slump 84% over the last decade. These facts are testaments to the high risk of this trust.

Final Thoughts

The above three REITs are offering exceptionally high dividend yields but for a good reason. They are vulnerable to the upcoming hikes of interest rates while they operate with a great amount of financial leverage. As a result, they are appropriate only for investors who expect limited interest rate hikes by the Fed and healthy economic growth for the foreseeable future. If one wants to choose one of the above three stocks, Annaly seems to be offering the least risky dividend right now thanks to its superior payout ratio and its decent balance sheet.