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Real Estate Investment Trusts (REITs) distribute most of their cash flows to their shareholders and thus they usually offer above-average dividend yields. Therefore, they are great candidates for the portfolios of income-oriented investors. However, investors should perform thorough due diligence before purchasing a high-yield stock to make sure that the dividend is sustainable. In this article, we will discuss the prospects of three REITs with exceptionally high dividend yields.
 

Orchid Island Capital (ORC)

Orchid Island Capital is a mortgage REIT and thus it differs from most well-known REITs. Most REITs own a portfolio of physical real estate, which they lease to tenants to collect rental income. On the contrary, mortgage REITs do not own any physical properties. They are pure financial entities, which invest in mortgage-backed securities. Orchid Island is an externally managed REIT (by Bimini Advisors LLC).

Mortgage REITs borrow funds at short-term interest rates and lend funds at longer-term interest rates. As a result, they are extremely sensitive to the spread between long-term and short-term interest rates. When the spread between long-term rates and short-term rates shrinks, profits evaporate at a rapid pace. This is the reason behind the high risk of mortgage REITs when the yield curve flattens.

Orchid Island is currently facing a strong headwind due to the aggressive interest rate hikes of the Fed in response to the surge of inflation to a 40-year high. Due to the rate hikes of the Fed, short-term rates have rallied this year and the yield curve has remarkably flattened, as investors expect the aggressive interest rate hikes to cause a recession at some point in the future. Consequently, Orchid Island is expected to post 10-year low earnings per share of approximately $0.69 this year.

Even if we exclude the headwind from a flattening yield curve this year, Orchid Island incurred a 56% decrease in its earnings per share between 2013 and 2021. It is also worth noting that its earnings per share have declined in 5 of the last 6 years. This helps explain the vast underperformance of the REIT vs. the S&P 500 over the last five years (-70% vs. +59%).

On the bright side, Orchid Island is offering an eye-opening dividend yield of 18.0%. It also has a payout ratio of 81%, which is high but less than 100%, thus signaling that the REIT can maintain its dividend, at least in the short run. Nevertheless, due to the high sensitivity of the trust to the spread between long-term and short-term interest rates, its dividend is not safe. Fortunately, the stock seems attractive from a long-term point of view. Even if it cuts its dividend by 50%, it will still be offering a 9.0% dividend yield.
 

ARMOUR Residential REIT (ARR)

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

Just like Orchid Island, ARMOUR Residential is extremely sensitive to the spread between long-term and short-term rates and thus it has exhibited a volatile performance record. The REIT has incurred a decline in its earnings per share in 8 of the last 9 years and thus its earnings per share have plunged 92% throughout this period. This helps explain the 89% plunge of the stock over the last decade.

ARMOUR Residential is currently offering an exceptionally high dividend yield of 17.3%. However, its payout ratio stands at 120%, and hence it is unsustainable. Moreover, the REIT has a weak balance sheet and it has cut its dividend significantly almost every year during the last decade. It is thus prudent to expect ARMOUR Residential to slash its dividend once again, especially given the strong headwind from the aggressive interest rate hikes of the Fed.
 

Two Harbors Investment Corporation (TWO)

Two Harbors Investment Corporation is a residential mortgage REIT and hence it focuses on residential mortgage-backed securities, residential mortgage loans, mortgage servicing rights, and commercial real estate.

Just like the aforementioned mortgage REITs, Two Harbors has exhibited a choppy performance record due to its high sensitivity to the path of interest rates. Two Harbors has been somewhat more reliable than the other two mortgage REITs but its earnings per share have collapsed since the onset of the coronavirus crisis. The trust has incurred a 75% slump in its earnings per share over the last nine years.

The stock is currently offering a 13.8% dividend yield with a payout ratio of 87%. The payout ratio signals that the dividend may be viable in the short run but is likely to be cut whenever the REIT faces a significant downturn. Two Harbors also uses less financial leverage than Orchid Island and ARMOUR Residential, but still, its dividend cannot be considered reliable. Investors should also be aware of the dramatic underperformance of Two Harbors vs. the S&P 500 over the last decade (-77% vs. +187%).
 

Final Thoughts

The above three REITs belong to the category of mortgage REITs, which usually offer extremely high dividend yields. This is certainly the case for these three mortgage REITs, which all offer a dividend yield above 13%. However, mortgage REITs are highly vulnerable to the shrinkage of the spread between long-term and short-term interest rates. As this spread has nearly evaporated this year, mortgage REITs are under great pressure right now and hence their dividends are not reliable.

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