On Monday, November 12, Annaly Capital Management (NLY), the largest mortgage REIT, announced that it plans to buy Crexus Investment Corp (CXS). Annaly is an agency mREIT that usually buys residential mortgage-backed securities that are guaranteed by government-sponsored agency entities such as Fannie Mae (FNMA.OB) and Freddie Mac. Crexus is a commercial mREIT in which Annaly already holds an over 12 percent interest. Crexus is also is managed by FIDAC, a wholly owned subsidiary of Annaly
Annaly announced the bid for Crexus as part of a change to its strategy in response to continued Federal Reserve purchases of government-backed residential debt. The addition of Crexus's holdings would mean NLY will no longer be an agency-only mREIT, but instead some sort of hybrid mREIT. Annaly normally buys not only residential paper, but residential paper with an agency backing, so CXS's commercial mortgage paper is rather different. Wellington Denahan, Annaly chairman and CEO, commented that:
Since our inception in 1997, Annaly has maintained the capacity to diversify its asset base to include real estate related assets in addition to Agency mortgage-backed securities if we determined that compelling other long-term investment opportunities exist relative to the Agency market. While we remain committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our shareholders' equity to real estate assets other than Agency mortgage-backed securities.
A powerful step in this direction is the proposed acquisition of CreXus. We believe that wholly owning the commercial real estate platform we currently manage through FIDAC is complementary to our existing business and return profile and should provide stable and diversified risk-adjusted returns to our shareholders.
The continued buying by the Federal Reserve has not only reduced mortgage yields, but also increased agency prepayment rates and reduced the spread between agency mREIT borrowing rates and the average agency-backed RMBS yield. Agency mREITs generally hold leveraged portfolios of agency securities to leverage that spread, and narrowing spreads makes this practice either less profitable or require higher leverage and its corresponding risk.
Annaly has decided to take another route and is now accepting the addition of alternative paper, including adding commercial mortgage-backed securities to its agency RMBSs. These CMBSs carry higher yields than agency-backed RMBSs because they are not considered default-proof, like agency paper is. Agency RMBS investors survived the real estate bubble because of that backing, and subsequently benefited from declining interest rates in the form of capital appreciation, while many non-agency-backed RMBSs and CMBSs fell apart.
It is also entirely possible and rather likely that Annaly will also add non-agency RMBSs to its portfolio, though such is no certainty. Given that Annaly may allocate as much as 25 percent of its equity into assets other than Agency RMBSs, more such acquisitions are possible. In response to this deal, Chimera (CIM) appreciated, as a possible next or later acquisition target. Chimera is a non-agency mREIT in which Annaly also owns an interest and that is also managed by FIDAC. Chimera also holds some agency RMBSs.
Chimera's shares have been volatile over the last 12 months due to accounting issues, but appreciated by about 8% in response to the Crexus offer announcement. In addition to constantly postponing filings, CIM has also had to reduce its dividend several times, until in August when it declared a plan to initiate a regular quarterly dividend of $0.09 per share for both the third and fourth quarter of 2012. Chimera noted that portions of the quarterly payout might be a return of capital.
It remains uncertain whether Annaly's unorthodox move out of agency RMBSs will work out well for the mREIT. The company is one of the largest mREITs, but has underperformed some of its newer rivals such as American Capital Agency Corp. (AGNC) over the last few years. Part of that outperformance may have been due to the ability of smaller portfolios to scale up their size in response to Federal Reserve buying.
Now most agency mREITs are concerned with being forced out of those positions due to rising prepayments, and are repurchasing shares rather than buying new securities. With declining spreads and rising prepayments, dividend cuts appear inevitable across the agency mREIT space. Some may follow Annaly out of the asset class, while others may choose to leverage up, or simply accept lower rates and risk. The best route is still unclear, but Annaly has chosen to change.