REITs: Paving the 2011 SUPER High-Income Highway AGNC, NLY

It’s been just over a week since the ball has dropped in Times Square, and New Year's Eve hangovers are ancient history. So are the performance figures for your portfolio over the previous 12 months.

How well you did likely had a direct correlation as to whether you were popping Dom Perignon corks on New Years, or opening cans of Welch’s Grape Juice. But now it’s 2011, and it’s a whole new ball game.

If you’re among the group of baby-boomers hitting 65 this year, there’s an excellent chance you’ve already focused your investment portfolio with a heavy bias towards one investing theme: income.
Of course traditional choices like bank CDs, “high yield” savings accounts, and U.S. Treasuries aren’t really choices at all.

Income from them won’t even feed your pets, let alone pay the rest of your bills and allow for a comfortable retirement. So what will you do? What’s the “big income idea” for 2011?

Monster Dividends

I’ve got one for you: Real Estate Investment Trusts, more commonly referred to as REITs. They have some of the highest yields on Wall Street.

Last year, REITs were one of the best performing areas in the financial sector, and are quickly becoming the “darlings” of investors in the know.

Most investors are drawn to REITs for their high-income producing ability, but some REITs have the ability to generate hefty capital appreciation as well.

The Vanguard REIT ETF (NYSE:VNQ) – which holds nearly 100 different REITs --closed out 2010 with a respectable 24% gain. That’s in stark contrast to the Financial Sector for the S&P 500, which pretty much flat-lined for 2010.

For 2011, I expect REITs to perform in a similar fashion as last year. But not all REITs are created equal, and not all will be stellar performers in 2011. We’ll get to two that will in a moment, but first let’s dig a little deeper into REITs.

What Makes REITs Such Great Investments?

Most of the success of REITs can be traced to one thing: cheap money. You see, when interest rates are low – as they were for all of last year – REITs can make a killing. Some are paying shareholders over 19% interest to shareholders. No, that’s not a typo.
That kind of performance can continue as long as interest rates stay low. The consensus among Wall Streeters is that they will. Here’s a few key reasons:

• Unemployment continues to hover just below 10%, and will likely remain there for the foreseeable future.

• Inflation is nowhere to be seen.

• “Quantitative Easing 2” (QE2) is imminent, and there’s already talk of a “QE3”.

So how do REITs offer the kind of killer returns we’re talking about?

Their business model is quite simple: they borrow money using low-interest, short-term vehicles. Then they use those funds to purchase high-interest, long-term securities. Investors pocket the difference, known as the “spread”, which can be substantial.

As long as interest rates remain low, they can continually refinance their short-term borrowings. This leads to solid profits, and that translates into big dividends for stockholders.

REITs are required by law to distribute 90% of its taxable income to its shareholders. This keeps dividend payments stable, further increasing their attractiveness to income-oriented investors.

Two REITs I Like for 2011

The first is Annaly Capital Mangement, Inc. (NYSE:NLY). Annaly owns, manages, and finances real estate investments.
Its portfolio includes mortgage pass-through certificates, collateralized mortgage obligations (CMOs), agency callable debentures, and various other securities. Most of these are purchased from Fed-backed Fannie Mae (NYSE:FNMA.OB) and Freddie Mac.

With a market cap of just over $11 billion, Annaly currently sports a 14.46% yield. Institutions own about 55% of the company’s stock, and it trades at a very reasonable P/E of 13.1
It’s hard for investors not to be giddy over the combination of high yield combined with the potential of capital appreciation, and virtually no default risk.

In stark contrast to commercial real estate lender iStar Financial Inc. (NYSE:SFI) – which continues to struggle -- Annaly is doing extremely well, and has strung together several quarters of strong results. This should keep those high dividends flowing to shareholders throughout 2011.

The second REIT I like is American Capital Agency Corporation (Nasdaq:AGNC). Similar in structure to Annaly, American Capital’s earnings come from investing in residential pass-through securities and CMOs.

Also similar to Annaly, these securities are also guaranteed by Fanny and Freddie. Some are also guaranteed by the Government National Mortgage Association (Ginnie Mae).

American Capital sports a whopping 19.21% yield. This is compelling value for income-oriented investors, to say the least.

In summary, it’s the “implied yield” for the property assets underlying REITs that’s the real secret to a REITs success. You see, in the form of REIT shares, that property effectively trades for significantly below the replacement cost.

You should steer clear of REITs that don’t invest in government backed securities. They carry significantly higher implied risk, with little difference, if any, in yield.

As long as interest rates and inflation remain close to zero, REITs will continue to generate significant earnings… and monster dividends for shareholders who decide to invest in them.

Annaly Capital Management and American Capital are two great examples of REITs who will have you popping champagne corks a year from now.

Disclosure I am long AGNC, VNQ, and NLY shares with no plans to sell anytime soon