Updated June 15, 2021 by Bob Ciura

Investors are likely familiar with common real estate investment trusts or REITs. Most REITs own physical properties, rent the properties to tenants, and generate rental income that is used to pay dividends.

However, there is another set of REITs that investors may not be as familiar with: mortgage REITs. These REITs do not own any physical real estate, but instead buy mortgage securities.

Mortgage REITs typically have much higher dividend yields than standard REITs, but that doesn’t necessarily make them better investments.

Orchid Island Capital (ORC), for example, is a mortgage REIT with an extremely high dividend yield of almost 14%. Orchid Island pays dividends every month, which makes it even more attractive as a dividend stock. It’s one of fewer than 60 monthly dividend stocks.

You can download our full Excel spreadsheet of all monthly dividend stocks (along with key metrics like dividend yield and payout ratio) by clicking the link below:

Orchid Island has an exceptionally high dividend yield and is one of the highest yielding stocks we cover.

The outlook for mortgage REITs is in doubt, however, and Orchid Island’s dividend yield may still not be sustainable after several dividend cuts in recent years.

This article discusses why income investors shouldn’t be drawn to Orchid Island’s extremely high dividend yield.

Business overview

While traditional REITs own a real estate portfolio, mortgage REITs are purely financial institutions. Orchid Island is an externally managed specialty finance company. Orchid Island invests in residential mortgage-backed securities, either pass-through or structured agency RMBS.

Source: Investor Presentation

An RMBS is a debt instrument that accumulates cash flows based on home loans such as mortgages, home loans, and subprime mortgages. Mortgage-backed securities are an investment product that is a basket of bundled loans.

As investors learned firsthand during the 2008 financial crisis, mortgage-backed securities can be very volatile and risky. However, mortgage REITs were among the biggest winners as rates fell after the Great Recession.

Growth prospects

Mortgage REITs make money by borrowing at short-term rates, lending at long-term rates, and pocket the difference or spread between the two.

When the spread between short-term and long-term interest rates narrows, profitability erodes. This is why mortgage REITs can become dangerous when short-term interest rates rise.

However, the Federal Reserve is not expected to hike rates for some time, especially as the COVID-19 pandemic remains an overhang for the economy. However, if inflation picks up pace, the Fed could raise rates in 2022.

Orchid Island has not seen any significant growth in recent years. The company has Experienced extreme earnings volatility in recent years with a net loss in 2013 and 2018, along with several years in which the trust hardly made any profit.

Orchid Island’s inability to perform well at zero interest rates makes it unlikely that the trust will regain a foothold when rates eventually rise again.

On April 29June 2021 The capital of Orchid Island reported Q1 Results. Net iInterest income was 24.9 Million, up to 30% of $19.1 million yearoveryear. Book value per share fell by 9.5% in a quarterly comparison. USD4.94. The company too reported net realized and unrealized losses of $ 50.8 million on RMBS and derivative instruments, including net interest Expense for interest rate swaps.

Dividend analysis

Orchid Island’s eroding fundamentals have resulted in a significant decline in dividend payments to shareholders in recent years.

Orchid Island currently pays a monthly dividend of $ 0.065 per share, which is 18% higher than the same monthly dividend paid a year ago. While the dividend increases in 2020 were a positive sign, Orchid Island’s dividend payout is still below the $ 0.08 per share monthly dividend paid in early 2020.

Looking back, Orchid Island’s monthly dividend payout peaked at $ 0.18 per share in 2014, but has been scaled back several times since then.

On an annual basis, the Trust currently has a dividend payout of $ 0.78 per share. Based on its most recent closing price, the stock offers a dividend yield of 13.9%. This is a tremendous dividend yield considering the S&P 500 Index’s average dividend yield is currently below 2%.

However, there are too many red flags on Orchid Island to be considered an attractive investment, including the trust’s multiple dividend cuts over the past few years and inconsistent profitability over this period.

In addition, Orchid Island has issued a large amount of shares in recent years. While the trust reduced its outstanding shares by 7.4% in 2018, Orchid Island’s number of shares has skyrocketed since 2013. This is associated with high costs for shareholders in the form of severe dilution.

With a volatile dividend history, Orchid Island is not an attractive choice for investors looking for steady dividend payouts year on year.

Orchid Island’s stock appears to be the definition of a yield trap. While the stock’s consistently high yield may attract income investors, the total annualized return over the past 5 years has been just 3.3%, even when dividend payments are factored in.

The stock has outperformed the S&P 500 index well, and we believe this underperformance is likely to continue.

Final thoughts

Sky-high dividend yields can be deceiving. Orchid Island’s dividend yield of nearly 14% is tempting, but this stock has what it takes to be a yield trap.

The trust has a significant amount of debt on its balance sheet and is issuing shares at an alarming rate. The outlook for mortgage REITs has improved in recent years due to low interest rates. While this benefited the mortgage REIT industry, Orchid Island remained weak. The trust’s final quarter showed an improvement in net interest income but a decrease in book value per share.

Orchid Island has cut its dividend several times over the past few years due to poor fundamental performance. Investors should be very careful with mortgage REITs like Orchid Island. As a result, income investors would be better off buying higher quality dividend stocks with more sustainable payouts.

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