Investors seeking income are pulling out all the stops to get what they need. Rather than retreating to traditional income-producing investments like bonds, income investors have had to get fancy with their portfolios, looking at specialized investments that many have never seen before.

In this week-long look at various types of income investments, today we're looking at mortgage REITs. With extremely high dividend yields, mortgage REITs have had no shortage of advocates, but after years of delivering solid income, some cracks have begun to appear in some of their business plans. Let's take a closer look at these income-producing powerhouses to see if the returns still outweigh the risks involved.

Making money from mortgages
Mortgage REITs are real estate investment trusts that predominantly invest in mortgage-backed securities. The benefit of the real estate investment trust structure is that by agreeing to pay at least 90% of their net income out to shareholders in the form of dividend distributions, REITs don't have to pay any corporate-level tax. That saves shareholders from an extra level of taxation that would otherwise sap a good-sized portion of their profits away, and it also guarantees that REITs will reward them with dividend payments whenever they're profitable.


But in recent years, the hallmark of successful mortgage REITs has been leverage. With extremely low short-term interest rates, mortgage REITs can borrow money for short periods of time at very little cost, and then turn around and reinvest those borrowings in mortgage-backed securities that provide income based on higher prevailing longer-term interest rates. The mortgage REIT can take those newly purchased securities and use them as collateral to borrow still more money, repeating the cycle until the entity owns a far bigger portfolio of assets than its initial capital would have suggested was possible.

The magnified profits from mortgage REITs' levered strategy have led to huge dividend payouts. Annaly Capital , American Capital Agency , and ARMOUR Residential have used agency-backed mortgage securities to produce double-digit dividend yields, while Chimera Investment has used a different approach, using less leverage but focusing on mortgage securities not guaranteed by agencies like Fannie Mae.

Running out of mortgages?
The insatiable appetite that investors have had for mortgage REITs has led to huge demand for an increasingly scarce supply of mortgage-backed securities. As of the end of the third quarter, Annaly, American Capital Agency, and ARMOUR accounted for nearly $240 billion in mortgage security holdings.

When you add in the fact that the Federal Reserve has turned the attention of its quantitative easing activity toward mortgage-backed securities, demand has pushed prices of those securities much higher. That in turn has reduced their yield and left shareholders with less profit, pressuring dividends lower.

Can the income last?
We've already seen a big impact in payouts among top mortgage REITs. Consider:

  • Annaly has cut its dividend seven times in the past three years, with its latest dividend down a third from its fourth-quarter 2009 payout.
  • Chimera's dividend has fallen by half in just two years.
  • ARMOUR pays almost a third less than it did in mid-2010.

Even American Capital Agency, whose dividend has been the most consistent, cut its dividend by 10% in early 2012.

Moreover, share prices of many mortgage REITs have fallen along with income levels. Given the high dividend yields, shareholders can afford a decent amount of capital loss while still maintaining positive total returns. But as perceived risk levels increase, even hefty dividends may not be enough to prevent overall losses for mortgage REITs going forward.

Finally, Annaly's recent offer to buy Crexus suggests that mortgage REITs are having to consolidate to find growth. That reflects their possible inability to grow organically.

Where can you find income?
As attractive as mortgage REITs may seem, they certainly have their associated risks. So where else should you look for income? Stay tuned tomorrow as I take a closer look at another income-rich area of the market: master limited partnerships.

Learn a lot more about industry-leader Annaly Capital in our premium research report on the mortgage REIT. Inside, you'll get even more detail on the specific issues that Annaly faces, with an eye toward revealing whether Annaly is a screaming buy after its recent share-price plunge. Click here now to claim your copy.

The article Mortgage REITs: Your Best Buy for Dividends? originally appeared on Fool.com.

Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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