Is Annaly Capital Management a Buy?

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A big piece of investing is balancing risk and reward. When investors look at Annaly Capital Management (NYSE: NLY) and its huge 11% dividend yield, this fact needs to be front and center in their minds. Although this company is a real estate investment trust (REIT), it isn't exactly your typical REIT. Here's what you need to understand before jumping on the chance to add this huge yield to your income portfolio.

What do you really own?

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The vast majority of REITs are landlords. They own physical assets that are leased out to tenants. If a tenant were to stop paying, then the company would simply find another tenant or sell the asset (even without a tenant, most properties tend to hold their value fairly well). Most property REITs generate pretty stable income over time and have the backstop of owning a real asset. This is one of the big reasons why investors like REITs. They provide a way to own a diversified portfolio of investment-grade rental property -- and benefit from the income such assets throw off -- without having to do any of the legwork.

Annaly doesn't do that. It is a mortgage REIT, buying and selling mortgages, not properties. To be fair, many traditional, property-owning REITs also invest in mortgages, but the exposure to mortgages is generally tiny relative to the physical assets they own. A pure mortgage REIT is very different from the idea most investors have about real estate investment trusts.

A typical REIT will use debt to build its portfolio. That debt may not be directly backed by the properties it owns (as a mortgage would be), but it owns physical assets that have intrinsic value. In a worst-case scenario, it could sell these assets to repay its debts. A mortgage REIT also uses debt (generally a lot of it), but it uses the loans it takes out to buy other loans (such as mortgages). It's making the spread between its interest costs and the rates it earns on the loans it buys with that cash. In theory, this is a simple and potentially profitable operation.

However, one big problem is that a mortgage is basically just a piece of paper. The only thing backing a mortgage is the ability and willingness of the borrower to continue paying the loan. Yes, there is an asset backing that loan (such as a home), but evicting a borrower and taking possession of that asset is a long and often difficult process. And even then, it isn't necessarily reasonable, since Annaly often buys loans that have been pooled together into collateralized loans (this, as you might expect, complicates the process of dealing with delinquent borrowers). Selling a loan that isn't being paid, meanwhile, isn't a great thing either, since such non-performing loans often trade for pennies on the dollar relative to performing loans. In other words, there's not much of a backstop for a mortgage REIT if something goes wrong.

The deep 2007-09 recession was a lesson in what can go bad with this business model. Although, to its credit, Anally survived the so-called Great Recession, a number of notable mortgage REITs declared bankruptcy when a large number of homeowners couldn't, or chose not to, pay their mortgages. If you are a conservative investor who doesn't want to spend a lot of time monitoring your portfolio, then you should simply avoid mortgage REITs like Annaly. Stick to REITs that own physical property.

But that 11% yield!

If you are still enticed by the huge dividend yield offered by Annaly, however, there's more to the story to consider. Annaly operates four distinct divisions: Agency, Residential Credit, Commercial Real Estate, and Middle Market Lending. This gives a bit of diversification to the portfolio. However, more than 90% of its assets are in the Agency business, so that's its big driver.

This is probably a good thing, overall. The Agency business buys collateralized loans backed by government agencies such as Fannie Mae and Freddie Mac. It's one of the largest players in the space, which it considers defensive because of the implied government backing of the loans. That said, if Annaly's funding costs go up because interest rates are changing, its margins will get squeezed and its profits will fall.

This is because the rates on the mortgages it buys are locked in for 20 to 30 years, while its funding costs are more variable. Yes, low interest rates can be very beneficial, but rising rates are not a good thing. That said, this has to be juxtaposed against the fact that the rates borrowers pay on new loans fluctuate with interest rate changes, as well. As rates fall, Annaly ends up replacing expiring loans with new ones at lower interest rates. That's not a good thing, either. There are complex interactions at work, and the impact of interest rates is a key factor that has to be managed constantly. It's the main issue with which management has to deal.

The other businesses the company operates are much smaller, but generally take on more risk. For example, Residential Credit buys loans that aren't backed by a government agency. If something goes wrong (like a recession that leads to an increase in defaults, for example), there's no backstop. Commercial Real Estate invests in loans backed by business assets, a very different property type. While an individual might make the emotional decision to tighten his or her belt to keep current on a loan (saving the home and the equity built up), a struggling business is more likely to make a business decision and declare bankruptcy. That could quickly leave Annaly in a tough position.

The Middle Market group, meanwhile, originates loans to companies based mainly on their ability, and willingness, to pay (not physical assets). The company considers this business defensive, but that might prove overly optimistic in a recession. That said, these loans generally have floating rates, so the risk of rising rates is offset somewhat, although it's possible for rates to rise so much that a company stops paying.

Although the idea of buying mortgages and loans is pretty simple, it isn't really as easy as it sounds. Interest rates and the economic outlook can have a huge impact on the income Annaly shareholders receive in dividends.

Speaking of which, here's a closer look at the company's dividend.

The REIT's dividend has been held at $0.30 per quarter per share since 2014. But don't get too complacent. It was $0.75 per quarter per share at the start of 2010, heading generally lower for several years before settling at $0.30. If you had owned the shares since late 2009 (the end of the Great Recession), your income would have been cut by 60% while the company's share price was trimmed by a painful 48%. Sure, the dividend has been steady for the past several years, but history suggests most investors would be better off sticking to a REIT with a lower yield and a stronger dividend-paying history.

Just not worth the risk

If you are looking at Annaly because of the REIT's huge yield, stop. This is not a typical REIT; it borrows money to invest in loans -- a very different REIT business model that hasn't performed particularly well in recent years. Annaly's dividend history and share price attest to that. The REIT has managed reasonably well, and some market watchers are quite fond of it and its business model, but most investors would be better off sticking to far more boring property owning REITs. If you do decide to invest here, however, remember that interest rates are a huge issue that you'll need to keep in mind because of the outsized importance they play in Annaly's results. This is not a set it and forget it type of investment.

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Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.