Should You Buy High Dividend REITs? The Motley Fool and I Disagree.

The market is already driving interest rates higher.  This is going to narrow profits at all of the REITs.  These high dividend stocks are for short term investors looking for a quick 3.5-5% quarterly dividend.  Remember that they are not qualified dividends that are taxed at 15%.  They are taxed as ordinary income (meaning 25% – 35%) for higher income investors.  Buy these at the bottom of the next crash if you really believe in the sustainability of there business models.

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The Federal Reserve is not currently in control of the Fed Funds rate (the rate that banks charge each other for overnight loans to meet their reserve requirements).  The large commercial banks are in control of this rate because they are flush with over a trillion dollars in excess reserves.  They aren’t borrowing from each other overnight.  The short term rates can and will rise outside of the Federal Reserves control.

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    Rising Star Buy: Annaly Capital

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    This article is part of our Rising Star Portfolios series. You can read about the Dada Portfolio here.

    Unemployment is obstinate, companies are operating below capacity, and inflation is low.

    Are there any companies that can actually benefit from the slump?

    Why, yes there are
    The name that’s caught my interest is Annaly Capital(NYSE: NLY), one of the largest publicly traded residential real estate investment trusts (REITs).

    Annaly’s business model seems complicated, but it’s actually pretty straightforward: Imagine if you could borrow $10,000 at 2%, lend it at 4% to a guaranteed borrower, and keep the $200 difference.

    That’s Annaly’s business in a nutshell. The company issues shares to raise capital, which it levers up with short-term financing. It uses this capital to buy longer-term mortgage-backed securities (MBS’s), collects the interest on these securities or sells them, and then repays its lenders.

    Virtually all the leftover profit is returned to shareholders via dividends. This currently works out to a 15% yield. (As a REIT, Annaly is required to distribute least 90% of its earnings as a dividend in exchange for not having to pay corporate income taxes. However, this dividend can be taxed differently than normal dividends.)

    The diagram below shows how it all comes together, with arrows representing money flows:

    anImage

    Shareholders and lenders provide Annaly with capital which the company uses to buy mortgage-backed securities.

    The bulk of Annaly’s profit is the difference between the short term rates at which it borrows, and the long termrates at which it lends, multiplied by the amount ofleverage it employs – currently 6.4 times.

    This is similar to the profit model employed by many proprietary traders at banks likeGoldman Sachs (NYSE:GS)JPMorganBank of America (NYSE: BAC), andCitigroup (NYSE: C). The difference is that Annaly’s investments are probably safer (all of them are issued and guaranteed by U.S. government agencies), a greater portion of the rewards are distributed to shareholders rather than as bonuses to traders, and proprietary trading will theoretically become illegal for the aforementioned banks should regulators actually enforce financial reform legislation.

    There are other companies similar to Annaly, such asAmerican Capital Agency (Nasdaq: AGNC)Hatteras Financial (NYSE: HTS), and Annaly-managed Chimera(NYSE: CIM). But Annaly’s bigger, has an ultra-safe portfolio, a long track record, and a strong management team headed up by Michael Farrell.

    Here’s where things get good
    When inflation is too low and unemployment too high — as is the case today — the Federal Reserve lowers short term interest rates to stimulate the economy. The Fed is currently targeting 0%-0.25%, pretty much as low as you can go.

    Since short-term rates are more responsive to the Fed’s low interest rate targeting and Annaly borrows at short-term rates to purchase longer-term securities, its costs have fallen significantly faster than the interest it collects.

    Check out how the declining Fed funds rate (green) drags down Annaly’s borrowing costs (red) much faster than its investments yield (blue). The area between red and blue is Annaly’s interest spread (profit):

    anImage

    Source: Company filings and the Federal Reserve Bank of New York.

    This is an awesome environment for Annaly. The current spread of 2.11% (the area between the blue and red lines and the key determinant of the company’s profitability) — is nearly double its historical average of approximately 1.20%.

    And it’s one that’s likely to persist for some time. As it’s exceedingly unlikely we’re going to see any meaningful economic stimulus to address unemployment emerge from the soon-to-be Republican-controlled House of Representatives and dysfunctional Senate, we can expect the slump – and low interest rates – to continue for some time. Traditional monetary rules prescribe as many as four years (!) of near-zero percent interest rates to cope even with mainstream economic forecasts.

    Scenarios galore
    Here are a few possible scenarios and their outcomes for our investment in Annaly, ranked from most to least likely.

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    Published in: on January 9, 2011 at 6:06 pm  Leave a Comment  

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