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Looking for Cheap Income? Be Sure You Know What You're Looking At

Jason is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

REITs have been on income investors' radar for the past few years, as traditional income sources like bonds yielding record-low levels. With mortgage REITs like Annaly Capital Management (NYSE: NLY) and American Capital Agency (NASDAQ: AGNC) paying out dividends over 15%, and at times well above 20% for American Capital, it’s a tempting place to invest. 

Warren Buffett and Mae West have both said that too much of a good thing can be wonderful, but don't expect good things to always be where you expect. Let's take a look at these two mREITS, plus an alternative that may be a better bet.

Interest rates rising = pressure on the rate spread

While it may sound counterintuitive, rising interest rates don't necessarily help mREITs make money. These companies use short-term debt (which is the interest rate you hear about on the news) to acquire the bundles of mortgages that it collects the interest and principal on. And unless the MBS that it buys are variable rate (it’s a small amount of their investments) the "spread" between the rate it's paying on the short-term debt, and the rate it's collecting from mortgage holders, gets squeezed.

Both have cut dividends multiple times in the past few years, and the market has punished them heavily this year, with shares down 23% and 30% respectively on fears of continued dividend declines. But before you assume that shares have bottomed out, there’s more to be concerned about.

If rates increase enough, further squeezing the spread, income seekers could further divest their mREIT shares and look to other income sources in the years ahead. In short, you could end up in a pickle, being forced to sell your shares for income because the dividend dried up, and selling at a loss at that.

Additionally, mREITs have little in the way of competitive advantage versus one another, which makes management execution incredibly important. Annaly recently changed its management to an external structure, where management is all contract-based, and not employed by Annaly.

And while this does potentially reduce expenses, it’s still a matter of management (and it’s the same team, just no longer directly employed by the company), effectively managing the portfolio through this cycle of increasing rates.

Putting the Real Estate back in REIT

If you're anything like me, you've probably noticed a lot of empty commercial real estate over the past few years. Retail Opportunity Investments Corp (NASDAQ: ROIC) CEO Stuart Tanz and his team are doing an admirable job of acquiring distressed, high-upside properties below market value and turning them into profitable, shopper- and merchant-filled destinations. 

These efforts are paying off. Per the May 2013 quarterly earnings release, occupancy rates are over 93%, and same-center net operating income grew 7.9% over the year-ago quarter. Both of these items contributed to a net income of $2.3 million in the quarter; more than double the year-ago period.

Lastly, debt is at a very manageable level, so this fast grower will continue expanding as shown by the four new properties acquired in Q1.

Bonus trivia: If you’d bought Annaly shares in June 2010, the current dividend yield would be about 6% based on your purchase price, and paying you 40% less than you were getting when you bought. If you’d bought ROIC shares, the current dividend would pay you a similar 6% yield.

The real difference? Annaly’s dividend (and share price) is going down, while ROIC’s is heading higher as the company grows.

Foolish bottom line

The 5-year total return for ROIC is 69%, to 60.6% for Annaly. Sure, American Capital has returned 268% over that time, but I’m convinced that the heady days of high spreads are done until interest rates stabilize, and that could take several years.

ROIC, on the other hand, is better positioned for sustained growth. The economy is getting slowly better, which will continue to expand the opportunities for Tanz and his team to make strategic acquisitions and further growing both the bottom- and top-line.  While today’s dividend of 6% may be low, there’s plenty of reason to project it to continue to grow over the next few years. 

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Jason Hall owns shares of Retail Opportunity Investments. The Motley Fool recommends Retail Opportunity Investments. The Motley Fool owns shares of Retail Opportunity Investments. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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