I’m a dividend investor. Like most dividend investors, I am drawn to stocks with high dividend yields. But I’ve learned the hard way that the highest yield isn’t always the best investment option. This is particularly true for those attempting to build an income stream to help support them in retirement.
The risk of investing based only on dividend yield is highlighted by the comparison between 13%-yielding AGNC Investment(NASDAQ: AGNC) and 5.6%-yielding Realty Income(NYSE: O). Here’s what you need to know.
Realty Income is one of the largest property-owning real estate investment trusts (REITs) in the world. It focuses on single-tenant properties that are leased out using a net lease structure. A net lease requires the tenant to pay most property-level operating costs. Although any single property is high risk, given there’s only one tenant, across a large portfolio, the risk of this approach is quite low. Realty Income owns over 15,500 properties, multiples of most competitors in the net lease niche.
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In addition to that fact, Realty Income has an investment-grade-rated balance sheet. It also has diverse geographic exposure, with assets in the United States and throughout Europe. And while most of its portfolio is in the retail property sector, it has some exposure to industrial properties and a mix of unique one-off assets, like casinos and vineyards.
The one thing that Realty Income isn’t is exciting. In fact, it is shockingly boring. That is actually a selling point for dividend investors, noting that the dividend has been increased annually for 30 consecutive years. The pace of dividend growth over that span was just 4.2% a year, but that’s slightly higher than the historical growth of inflation. In other words, the buying power of the dividend has grown over time.
Now add in the 5.6% dividend yield, which is well above the 1.1% yield of the S&P 500 index and the 3.9% yield of the average REIT. Realty Income is a foundational high-yield investment.
AGNC Investment actually does a fairly good job of achieving its goal of total return. The problem is that total return requires the reinvestment of dividends. That changes the entire equation if you are trying to build an income-producing portfolio. Sure, AGNC’s 13% yield is huge, but if you spend that cash, you will likely end up highly disappointed with the outcome you achieve.
The chart below sums up everything you really need to know. Notice the blue line, total return, which heads steadily higher. That is an indication that AGNC Investment is achieving its primary goal of total return. Since its initial public offering, the REIT’s total return is actually a little bit better than that of an S&P 500 index ETF. But dividend investors need to look at the orange and purple lines, too.
Dividends, represented by the orange line, have been highly volatile and have been in a steady decline for several years. The stock price, the purple line, has generally followed along for the ride. If you spent the dividends you collected from AGNC Investment, you would have been left with less capital and less income. Most dividend investors want the exact opposite of that.
AGNC Investment’s business model is important in understanding why its dividend is so volatile. The company is a REIT, but it is focused on owning mortgages that have been pooled together into bond-like investments. Like a mutual fund, it is basically managing a portfolio. In this case, the portfolio consists of mortgage securities. Dividend increases and dividend cuts are a normal part of the process throughout the mortgage REIT sector as these companies navigate the ups and downs of the housing, mortgage, and bond markets. Ultra-high yields are also the norm, even though the dividend backing those yields is often very volatile.
Investing is an emotional process for most investors, even if they are not aware of it. I can’t help but get excited when I see an ultra-high dividend yield, but I’ve learned that I need to step back and understand the business that supports that yield. Most of the time, the highest yields come with risks I’m not willing to take on.
In this matchup, Realty Income’s yield is more suitable for my income needs than AGNC Investment’s much higher yield. I suspect that will also be true for most dividend investors, who, like me, are looking to build a reliable income stream.
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Reuben Gregg Brewer has positions in Realty Income. The Motley Fool has positions in and recommends Realty Income. The Motley Fool has a disclosure policy.
