A REIT With Risk

Newcastle Investment (NCT) recently closed a secondary stock offering at $9.35 per share in which two company insiders, Secretary Randal Nardone and Director Wesley Edens, each bought about $1 million worth of stock, respectively.

We track insider purchases because, on average, stocks bought by insiders tend to outperform the market, with multiple insider buys being a particularly good sign. We believe that this is because insiders are already tied to the company's prospects, so to buy more shares, as Nardone and Edens did, they have to be confident that the stock is undervalued. The same two insiders had bought shares in another offering in July 2012 at $6.70 per share; obviously, the stock is up significantly since that time. Newcastle's stock price has doubled in the last year, bringing it to a market capitalization of $1.7 billion.

Newcastle is a real estate investment trust, or REIT, which owns mortgage-backed and asset-backed securities. As might be expected from that description of its business, the stock's performance has a strong correlation with that of the broader market: specifically, the beta is 2.2. Net interest income, including and excluding impairments, was higher in the third quarter of 2012 than in the same period of 2011. Net interest income is a key financial metric for financial companies such as Newcastle; earnings aren't very useful when evaluating REITs.

Many income investors are attracted to REITs because they are required to pay 90% of taxable income to shareholders to maintain their preferable tax status, which tends to result in high dividend yields. In Newcastle's case, the company stopped making dividend payments after October 2008 -- which is understandable because the stock price dropped 93% in that year -- and resumed payments in June 2011. That historical record, along with the high beta that we noticed earlier, suggests that even income investors should avoid the stock if they are not willing to take on the risk inherent in real estate-related investments. The mortgage-backed securities are particularly worrisome.

With that said, Newcastle paid a $0.10 per share dividend in June 2011, upped it to $0.15 the next quarter, then $0.20 two quarters after that, and then $0.22 for the third and fourth quarters of 2012. If we assume that the company pays out $0.22 per share to shareholders each quarter for a year, or $0.88 for the full year, the dividend yield at current prices is 9%. Remember that there is a considerable downside risk to Newcastle, but that is a good yield and it's possible that dividend payments will increase further.

We don't think there's any better way to characterize Newcastle than a blunt "high risk, high reward." There's certainly a possibility that poor real estate conditions will cause the stock to plummet and dividends to cease. For most investors, this would come as the rest of their investments (including a home, if they own one) declined in value as well. Yet from a yield-seeker's perspective, a 9% dividend yield is very high and certainly beats many of the alternatives in a low-interest rate environment (as well as many traditional dividend stocks). In addition, because of these insider purchases, we know that at least two insiders are so confident that Newcastle will avoid the downside case that they are willing to invest more of their own money in the stock -- and they would be among the hardest hit of all if the company did underperform and send the stock price down dramatically.

At the time of publication, Krishnamsetty had no positions in any of the stocks mentioned.