How Do These High-Yielding REITs Really Make Their Money?

American Capital Agency Corp. (AGNC) and the other high dividend stocks called REITs are quite leveraged.  They are at the mercy of the banks that issue/supply their repurchase agreements.  They are borrowed short (repurchase agreements) and lent long (agency securities) just like commercial banks.  That’s fine so long as there are no financial crisis’s looming in the future.  Guess what?  The structural problems caused by fractional-reserve banking are not fixed.  Central banks around the world are printing money which just masks the problems and make them worse.

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They pledge their existing assets (agency securities) as collateral to other banks in return for a very short term loan through repurchase agreements.  The repurchase agreements loans and new stock offerings get them the capital necessary to purchase new agency securities from Fannie, Freddie, and to a lesser extent Ginnie.  They use the income generated from the agency securities and the sale of some agency securities to pay off the repurchase agreement loans when they come due.  Some of the risks to their income are badly performing agency securities (remember those toxic mortgage backed securities and what happens when people who are unemployed stop paying their mortgages) and a decline in the price of agency securities (for the same reason mentioned and Federal Reserve intervention in the MBS market).

Because they are borrowed short and lent long they won’t have the money coming in to keep their current dividend payments during the next financial crisis.  For example, AGNC has a quick ratio of 0.08.  I like to see this ratio above 1.0 meaning that the company has more current assets than current liabilities.  The cash equivalents that AGNC has on hand (current assets) are miniscule compared to their billions in repurchase agreements (current liabilities).

For comparison let’s look at Safe Bulkers quick ratio.  It is 3.30.  They have over three times their current liabilities in current assets that could be liquidated in an emergency to keep paying their fat dividend.

How Do These High-Yielding REITs Really Make Their Money?

By Jim Royal
January 18, 2011

As investors, we need to understand how our companies truly make their money. And there's a neat trick developed for just that purpose. It's called the DuPont Formula.

By using the DuPont Formula, you can get a better grasp on exactly where your company is producing its profit and where it might have a competitive advantage. Named after the company where it was pioneered, the DuPont Formula breaks down return on equity into three components:

Return on equity = Net margins x asset turnover x leverage ratio

High net margins show that a company is able to get customers to pay more for its products. (Think luxury goods companies.) High asset turnover indicates that a company needs to invest less of its capital, since it uses its assets more efficiently to generate sales. (Think service industries, which often do not have high capital investments.) Finally, the leverage ratio shows how much the company is relying on debt to create profit.

Generally, the higher these numbers, the better. Of course, too much debt can sink a company, so beware of companies with very high leverage ratios.

Let's take a look at Annaly Capital Management (NYSE: NLY) and a few of its sector and industry peers.

Company	Return on Equity	Net Margins	Asset Turnover	Leverage Ratio
Annaly Capital Management	8.2%	79.7%	0.01	8.03
Chimera Investment (NYSE: CIM)	18.5%	91.6%	0.09	2.28
American Capital Agency (Nasdaq: AGNC)	28.4%	92.1%	0.03	10.46
Anworth Mortgage Asset (NYSE: ANH)	12.7%	88.2%	0.02	6.95

Source: Capital IQ, a division of Standard & Poor's.

Each of these companies offers a truly amazing dividend, ranging from 12.7% for Anworth to 19% for American Capital Agency. And how do these guys do it? This DuPont formula screen shows clearly: high leverage and fat net margins. Net margins for these group ranges from 80% to 92%, while most are very highly leveraged, with the exception of Chimera. Those tasty dividends bring out the gambler in some investors, which may explain why you might want to avoid some of these too-tempting stocks.

Breaking down a company's return on equity can often give you some insight into how it's competing against peers and what type of strategy it's using to juice its return on equity.

Jim Royal, Ph.D., owns shares of Annaly. The Fool owns shares of Annaly Capital Management.

Link to the original article: http://www.fool.com/investing/dividends-income/2011/01/18/how-do-these-high-yielding-reits-really-make-their.aspx

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