Real estate investment trusts, or REITs, have suffered since the recession hit. But many investors threw out the babies with the bath water. Annaly Capital Management ( NLY) and MFA Financial ( MFA) are two misunderstood REITs that offer huge yields and are poised to rebound. To further limit risk, consider gaining exposure to the two stocks through the First Trust Specialty Finance and Financial Opportunities ( FGB) closed-end fund or the Burnham Financial Services ( BURKX) mutual fund. Annaly is a REIT that manages a portfolio of securities, including collateralized mortgage obligations, pass-through certificates and callable debentures. As the subprime mania seized the market, the stock was battered. It has fallen 15% since February 2008. After posting a fourth-quarter loss of 95 cents a share, Annaly resumed profitability in the first quarter as net income rose 44% to $350 million despite a 10% drop in revenue. The operating margin remained exorbitant at 96%, and the net margin widened 28 percentage points to 48%. Like most REITs, Annaly's capital structure is skewed toward leverage, which is evident in its debt-to-equity ratio of 6. The trust invests in mortgage-backed securities that have actual or implied AAA-ratings. By doing so, it minimizes credit risk. And the company generates above-average returns by leveraging its positions. Although that strategy sounds reminiscent of Bear Stearns or Lehman Brothers, it isn't. The company efficiently regulates risk. Its operating performance has been remarkably consistent during a period of financial tumult. Annaly distributes income to shareholders through cash distributions. The yield is currently 15%, more than four times that of the S&P 500 Index. Mortgage-backed securities are still cheap because of investors' aversion to real estate and an effort by banks to purge their balance sheets of so-called toxic assets. Annaly is seizing the opportunity to borrow at low rates and invest in undervalued securities. The downside to its stock is affordability. The shares have surged 22% in three months and now trade at an expensive price-to-earnings ratio of 20. But the high yield compensates for a costly share price.
MFA offers a similar story. It's a mortgage REIT specializing in hybrid and adjustable-rate mortgage-backed securities. But MFA, unlike Annaly, swallowed its major loss in the first quarter of 2008 and has since achieved four consecutive periods of earnings growth. First-quarter revenue rose 28% to $132 million as the company swung to a net profit of $54 million, or 23 cents per share, from a loss of $86 million, or 61 cents per share, in the year-earlier period. The operating margin remained steady at 96% and the net margin stretched to 41%. The pitch is the same as Annaly, but MFA is cheaper. The stock trades at a price-to-earnings ratio under 7 and offers a 14% yield. TheStreet.com Ratings gives MFA a "hold" recommendation because it has a slightly weaker financial position.