Should You Forget AGNC Investment and Buy Starwood Property Trust Instead?

AGNC Investment (NASDAQ: AGNC) currently offers a big-time income stream. The real estate investment trust (REIT) boasts a dividend yield of more than 14%. That's 10 times higher than the S&P 500's 1.2% yield.

However, it's not the only high-yielding REIT that's enticing. Starwood Property Trust (NYSE: STWD) yields nearly 11% these days. The company has a more diversified portfolio and a longer track record of making consistent dividend payments. Here's why more risk-averse income investors might want to forget AGNC Investment and buy Starwood instead.

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A higher risk, higher reward payout

AGNC Investment has a very straightforward business model. It only invests in Agency residential mortgage-backed securities (MBS), pools of residential mortgages protected against credit losses by government agencies such as Fannie Mae. They're very low-risk fixed-income investments with fairly low returns (low-to-mid single digits).

The mortgage REIT invests in these Agency MBS on a leveraged basis, primarily through repurchase agreements. Using leverage can be a very lucrative investment strategy as it can significantly boost returns. For example, the REIT earned a return on equity of around 17% during the third quarter. That's currently right in alignment with its cost of capital (dividend payments plus operating costs). As a result, the REIT can maintain its dividend rate.

However, if AGNC's returns were to fall short of its cost of capital, the REIT might need to reduce its dividend payment. That has happened several times in the past. When AGNC Investment started paying monthly dividends in 2014, it set the rate at $0.22 per share. Today, it pays $0.12 per share, with the last cut coming in 2020. Given the history of reductions, investors can't bank on the REIT continuing to pay its current rate forever.

An increasingly safer payout

Starwood Property Trust is also a mortgage REIT. However, it has a much more diversified investment approach. Starwood has invested about 53% of its portfolio in loans backed by commercial real estate (including multifamily, office, industrial, hotel, and other properties). It also invests in residential loans (9% of its portfolio) and infrastructure-backed loans (10%). This diversified portfolio of loan investments provides the REIT with relatively stable interest income.

Additionally, Starwood invests directly in properties (19% of its portfolio), including medical offices, affordable housing, and net lease real estate. These direct equity investments generate stable and steadily rising rental income.

The REIT took a notable step toward increasing its diversification this year when it acquired Fundamental Income Properties in a $2.2 billion deal. The acquisition added a diverse portfolio of income-producing net lease properties backed by a 17-year weighted average lease term with an average annual lease escalation rate of 2.2%. As a result, it should provide the REIT with stable, reliable, and growing cash flow.

Starwood's diversified investment strategy has paid off for investors over the years. The REIT has maintained a stable dividend rate for over a decade and has never reduced its payment.

The finance company's diversification strategy not only helps reduce risk but also provides Starwood with greater flexibility to adjust its investment approach in response to market conditions. Whereas AGNC Investment must invest in Agency MBS no matter what's going on in the market, Starwood can focus on the best investment opportunities it sees in the market at the time. For example, Starwood invested $4.6 billion in the third quarter, including $2.2 billion to buy Fundamental Income and a record $800 million into infrastructure lending. The REIT capitalized on a unique opportunity to acquire a high-quality net lease platform that it anticipates expanding in the years to come. Starwood also leaned into investing in infrastructure-backed loans during this period, as they offered attractive risk-adjusted returns.

A better option for a more reliable income stream

AGNC Investment's focused investment strategy enables it to generate high returns, supporting its high-yielding dividend. However, its strategy carries more risk, as evident by the decline in its dividend over the years. Starwood Property Trust, on the other hand, aims to provide investors with a secure dividend backed by a diversified portfolio of assets. That lower-risk strategy makes it a better stock to buy for those seeking a stable stream of dividend income.

Matt DiLallo has positions in Starwood Property Trust. The Motley Fool has positions in and recommends Starwood Property Trust. The Motley Fool has a disclosure policy.