Updated on March 27th, 2019 by Nate Parsh
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.
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 14.2%.
It is one of 390 stocks with a 5%+ dividend yield, and is one of the highest-yielding stocks on the list. You can see the full list of established 5%+ yielding stocks here.
Plus, Orchid Island pays its dividend each month, which makes it even more attractive as a dividend stock. It is one of only 41 monthly dividend stocks. You can access the full database of monthly dividend here.
However, the outlook for mortgage REITs is challenged, and Orchid Island’s dividend yield does not appear to be sustainable.
This article will discuss why income investors should not be lured by Orchid Island’s extremely high 14% dividend yield.
Whereas traditional REITs own a portfolio of properties, mortgage REITs are purely financial entities. Orchid Island is an externally-managed, specialty finance company.
Orchid Island 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 and risky. This is the first reason 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, when the U.S. is entering monetary tightening cycle, their performance could deteriorate.
Source: Fourth Quarter Earnings Presentation, page 7
The Federal Reserve raised interest rates four times in 2018. Interest rates have been increased a total of nine times since 2015.
Higher interest rates have had a negative impact on the stock, as Orchid Island’s share price has declined almost 31% since interest rates began increasing in December 2015.
Orchid Island’s recent financial results have reflected this risk. 2018 marked another year of losses for the trust. In the fourth quarter, Orchid Island reported a net loss of $0.52 per share.
The trust generated a negative return on invested capital of 6.1% for the quarter. Plus, Orchid Island’s future growth outlook is challenged.
Mortgage REITs make money by borrowing at short-term rates, lending at long-term rates, and 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.
The Federal Reserve’s recent interest rate hikes are widely bearish developments for mortgage REITs.
For example, Orchid Island ended last quarter with an effective portfolio duration of approximately 2.078%. This means that an interest rate increase of 1.0% would cause a 2.078% decrease in the value of Orchid Island’s RMBS in its investment portfolio.
In fairness to the company, this decrease is approximately half of what it was just two years ago.
Still, Orchid Island stock is down 7.3% over the last year. And that’s with the Federal Reserve not expecting to increase interest rates this year unless the economy grows at a rapid pace.
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 2018, Orchid Island reported an earnings-per-share loss of $0.85 per share. This was only the second time since inception (2013) that the trust has produced a negative earnings-per-share result.
In the fourth quarter, net income increased $0.34 per share, but this was more than wiped out by $0.80 per share of RMBS and derivative losses, and $0.06 per share of expenses.
Net book value declined by more than 21% to $6.84 from 2017 to 2018.
Orchid Island’s eroding fundamentals have caused a significant drop in its dividend payments to shareholders in the past several years.
Orchid Island currently pays a monthly dividend of $0.08 per share, which is more than a 50% reduction from the trust’s monthly dividend in June 2015.
On an annualized basis, the trust has a current dividend payout ratio of $0.96 per share.
Based on its March 21st closing share price of $6.77 per share, the stock offers a 14.2% dividend yield. This is a huge dividend yield, considering the S&P 500 Index, on average, has a 1.9% dividend yield.
However, there are too many red flags for Orchid Island to be considered an attractive investment. After cutting its dividend twice in 2018, the trust has maintained its current dividend so far in 2019.
In addition, Orchid Island has issued shares at a high pace in recent years. While the trust reduced its shares outstanding 7.4% in 2018, Orchid Island’s share count has increased more than 17x since 2013.
This comes at a steep cost to shareholders, in the form of heavy dilution.
Plus, the trust’s annual earnings-per-share do not cover its hefty dividend payment. All of this seems to suggest a dividend cut is likely to occur again 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. Except for 2017 when the trust paused its dividend growth, it has cut its dividend every year since 2013.
With a volatile dividend history, Orchid Island is not an appealing choice for investors looking for steady dividend payouts from year to year.
Sky-high dividend yields can be deceiving. Orchid Island’s 14%+ dividend yield is enticing, but this stock has all the makings of a trap.
The trust 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 has cut its dividend several times in the past few years due to these pressures, and another dividend cut may be in the cards.
Investors should tread very carefully with mortgage REITs like Orchid Island. That dividend yield could prove to be a mirage—it looks great from a distance, but vanishes once you get close.
As a result, income investors would be better served buying higher-quality dividend stocks, with more sustainable payouts.