Updated on June 15th, 2021 by Bob Ciura
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 Capital (ORC) is a mortgage REIT, with an extremely high dividend yield of almost 14%. Orchid Island pays dividends each month, which gives it the compelling combination of a a high yield with monthly dividend payments. It is one of less than 60 monthly dividend stocks.
You can download our full Excel spreadsheet of all monthly dividend stocks (along with metrics that matter like dividend yield and payout ratio) by clicking on the link below:
Orchid Island has an exceptionally high dividend yield, and is one of the highest-yielding stocks that we cover.
However, the outlook for mortgage REITs is challenged, and Orchid Island’s dividend yield may still not be sustainable even after multiple dividend cuts in the past several years.
This article will discuss why income investors should not be lured by Orchid Island’s extremely high 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.
Source: Investor Presentation
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. That said, mortgage REITs were among the biggest winners as interest rates were falling during the aftermath of the Great Recession.
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.
However, the Federal Reserve isn’t expected to increase interest rates for some time, especially as the COVID-19 pandemic remains an overhang on the economy. Although if inflation picks up steam, the Fed could move to raise interest rates in 2022.
Orchid Island has not been able to produce meaningful growth in the past several years. The company has experienced extreme earnings volatility over the past several years, with a net loss in 2013 and 2018, along with multiple years in which the trust barely generated a profit.
Orchid Island’s inability to perform well with interest rates at zero makes it unlikely that the trust can regain its footing if and when interest rates eventually rise again.
On April 29th, 2021 Orchid Island Capital reported Q1 results. Net interest income came in at $24.9 million, up 30% from $19.1 million year–over–year. Book value per share declined 9.5% quarter-over-quarter to $4.94. The company also reported net realized and unrealized losses of $50.8 million on RMBS and derivative instruments, including net interest expense on interest rate swaps.
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 $0.065 per share, which is 18% higher than the same monthly payout level from one year ago. While the dividend increases in 2020 were a positive sign, Orchid Island’s dividend payout still remains below the $0.08 per share monthly dividend it was paying in early 2020.
Looking back further, Orchid Island’s monthly dividend payout reached a high of $0.18 per share in 2014, but has been reduced multiple times since then.
On an annualized basis, the trust has a current dividend payout of $0.78 per share. Based on its recent closing price, the stock offers a 13.9% dividend yield. This is a huge dividend yield, considering the average dividend yield of the S&P 500 Index is currently below 2%.
However, there are too many red flags for Orchid Island to be considered an attractive investment, including the trust’s multiple dividend cuts over the past few years and inconsistent profitability in that time.
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 skyrocketed since 2013. This comes at a steep cost to shareholders, in the form of heavy dilution.
With a volatile dividend history, Orchid Island is not an appealing choice for investors looking for steady dividend payouts from year to year.
Orchid Island stock appears to be the definition of a yield trap. While the stock’s consistently high yield may lure income investors, total annualized returns in the past 5 years have been just 3.3%, even when including dividend payments.
The stock has badly lagged the S&P 500 Index, and we believe this underperformance is likely to continue.
Sky-high dividend yields can be deceiving. Orchid Island’s nearly 14%dividend yield is enticing, but this stock has all the makings of a yield trap.
The trust has a sizable amount of debt on the balance sheet, and is issuing shares at an alarming pace. The outlook for mortgage REITs has improved in recent years due to low interest rates. While this benefited the mortgage REIT industry, Orchid Island’s performance remained poor. The trust’s most recent quarter showed improvement in net interest income, but a decline in per-share book value.
Orchid Island has cut its dividend several times in the past few years due to poor fundamental performance. Investors should tread very carefully with mortgage REITs like Orchid Island. As a result, income investors would be better served buying higher-quality dividend stocks, with more sustainable payouts.