Investors are likely familiar with the standard Real Estate Investment Trusts, or REITs. Most REITs own physical real estate, lease the properties to tenants, and derive rental income which is used to pay dividends.

But there is a different set of REITs that investors may not be as familiar with: mortgage REITs. These REITs do not own physical properties, but rather buy mortgage securities. You can see all 173 publicly-traded REITs here.

Mortgage REITs typically have much higher dividend yields than standard REITs, but this does not necessarily make them better investments. For example, Orchid Island (ORC) is a mortgage REIT, with an extremely high dividend yield of 16.8%. It is one of 405 stocks with a 5%+ dividend yield, and is one of the highest-yielding stocks on the list. 

Plus, Orchid Island pays its dividend each month, which makes it even more attractive as a dividend stock. It is one of only 34 stocks with a monthly dividend. However, the outlook for mortgage REITs is challenged. Orchid Island’s dividend yield does not appear to be sustainable.

This article will discuss why income investors should not be lured by the siren song of Orchid Island’s 16% dividend yield.

Business Overview

Whereas traditional REITs own a portfolio of properties, mortgage REITs are purely financial entities. Orchid Island is an externally-managed, specialty finance company. It invests in residential mortgage-backed securities, either pass-through or structured agency RMBSs.

An RMBS is a debt instrument that collects cash flows, based on residential loans such as mortgages, home-equity loans, and subprime mortgages. Mortgage-backed securities are an investment product representing a basket of pooled loans.

As investors saw first-hand during the 2008 financial crisis, mortgage-backed securities can be highly volatile. This is the first of many reasons why risk-averse income investors would be wise to steer clear of Orchid Island.

Mortgage REITs were among the biggest winners as interest rates were falling during the aftermath of the Great Recession. But, if the U.S. is about to enter a monetary tightening cycle, their performance could deteriorate.

Source: Q1 Earnings Presentation, page 9

Orchid Island’s recent financial results have reflected this risk. 2016 ended on a very bad note for the company. In the fourth quarter, Orchid Island reported a net loss of $0.72 per share. The company generated a negative return on invested capital of 6% for the quarter. Plus, Orchid Island’s future growth outlook is challenged.

Growth Prospects

Mortgage REITs make money by borrowing at short-term rates, and lending at long-term rates, then pocketing the difference, or the spread between the two.

When the spread between short-term rates and long-term rates compresses, profitability erodes. This is why mortgage REITs can be dangerous if short-term interest rates are about to increase.

Source: Q1 Earnings Presentation, page 9

The U.S. Federal Reserve’s interest rate hikes, and intention to trim its balance sheet, are widely bearish developments for mortgage REITs.

For example, Orchid Island ended last quarter with an effective portfolio duration of approximately 3.495%. This means that an interest rate increase of 1.0% would cause a 3.495% decrease in the value of Orchid Island’s RMBS in its investment portfolio.

This explains why Orchid Island stock is down 10% year-to-date. In the past five years, Orchid Island shares have lost one-third of their value.

Mortgage REITs are exposed to a number of risks, including interest rate risk, as well as credit risk. These risks pertain to the direction of interest rates, as well as the ability of borrowers to repay the mortgage loans.

In the first quarter of 2017, Orchid Island reported earnings-per-share of just $0.07, which badly missed analyst estimates, by $0.29 per share.

Net interest income rose 49% year over year to $0.77 per share, and beat estimates, but this was nearly wiped out by $0.63 per share of RMBS and derivative losses, and $0.07 per share of expenses.

Net book value declined $0.35 per share in the first quarter, to $9.75 per share. While Orchid Island managed a positive return on invested capital, it was just 1.5% for the quarter.

Dividend Analysis

Orchid Island currently pays a monthly dividend of $0.14 per share. On an annualized basis, the company has a dividend payout of $1.68 per share.

Based on its July 17th closing share price of $10.02 per share, the stock offers a 16.8% dividend yield. This is a huge dividend yield, considering the S&P 500 Index, on average, has a 2% dividend yield. However, there are too many red flags for Orchid Island to be considered an attractive investment.

The company has maintained its dividend so far in 2017, in part because of aggressive equity issuances. At the end of the first quarter, Orchid Island had 33.1 million shares outstanding, compared with 21.7 million shares at the same point last year. But this comes at a steep cost to shareholders, in the form of heavy dilution.

Plus, the company’s annual earnings-per-share do not cover its hefty dividend payment. All of this seems to suggest a dividend cut is likely over the next year, perhaps a significant reduction.

Orchid Island also does not have a long history of consistent dividend growth. It has paid dividends only since 2012. It has not raised its dividend since 2013, and reduced its dividend by 22% in 2015. With a volatile dividend history, Orchid Island is not an appealing choice for investors looking for steady dividend payouts from year to year.

Final Thoughts

Sky-high dividend yields can be deceiving. Orchid Island’s 16% dividend yield is enticing, but this stock has all the makings of a trap.

The company is not covering its dividend with earnings. It also has a sizeable amount of debt on the balance sheet, and is issuing shares at an alarming pace.

The outlook for mortgage REITs is challenged. Orchid Island cut its dividend two years ago due to these pressures, and it is likely another dividend cut is in the cards.

Investors should tread very carefully with mortgage REITs like Orchid Island. That 16% dividend yield could prove to be a mirage—it looks great from a distance, but vanishes once you get too close. As a result, income investors would be better served buying higher-quality dividend stocks, with more sustainable payouts.