American Capital Agency Corp. (AGNC), Annaly Capital Management, Inc. (NLY): Are Highly-Leveraged mREITs the Next Target of a Witch Hunt?

Another significant factor is that the latest investment in mortgage obligations was made on June 12, 2009. Mortgages issued in 2008 and 2009 were at higher interest rates that generated the net income passed onto shareholders. Looking at the chart below, aside from the very high debt-to-equity ratio, sales income when compared to market capitalization gives another red flag and begs the question, “is it prudent to invest in a company that has a market capitalization of $533.85 million and yet only generates $71.70 million in sales?” In my opinion with no new mortgage investments over the course of time, the existing portfolio can only decrease in size. Such downsizing will result in lower cash inflows and dividend payments. Based on this, I do not see any long-term prospects here.

Another subject of this increased awareness is Annaly Capital Management, Inc. (NYSE:NLY). The current share price is around $15.66, and with a dividend of $1.80, the yield is 11.49%. Annaly Capital Management, Inc. (NYSE:NLY)’s investment portfolio is not based entirely on mortgage obligations; real estate is owned and operated. The link to the website lists all of Annaly’s divisions: http://www.annaly.com/site/annalyfamilyofcompanies.aspx. Per the table below, the debt-to-equity ratio of 6.62 indicates a very high level of borrowed funds to continue operations. Regardless of the various entities, the exposure to low cost short-term financing carries significant risks to its operations when the inevitable rise in interest rates begins.

As stated earlier, I support the use of leverage to enhance returns, to a certain point. I believe that a recipe for disaster is in progress when the application of such leverage is expanded to enhance the gross returns of narrowing margins. The excessive levels of debt in relation to the equity of these companies should not be ignored simply due to the high current yields. I caution the average investor to make sure that he/she is comfortable with such debt levels and feels comfortable with how the management of these types of REITs manage interest rate risk.

The article Are Highly Leveraged Mortgage REITs the Next Target of a Witch Hunt? originally appeared on Fool.com and is written by Jeff Stouffer.

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