The first rule of business is that when your income is under pressure, think of ways and means to lessen or eliminate the pressure. This seems to be exactly the reason why Annaly Capital (NLY) thought of acquiring CreXus Investment (CXS), a company whose 12.4% of common stock it already owns and manages through its wholly owned subsidiary, Fixed Income Discount Advisory Company (FIDAC).
CreXus, a real estate investment trust (REIT) confirmed on Tuesday, November 13, 2012 that it had received an offer from Annaly Capital Management, Inc. to acquire the balance 87.6% shares of common stock that it does not already own at $12.50 a share. The buy offer is at 13% premium to the last reported stock price of CXS and nearly 16% premium to past 3-month average price.
Mortgage REITs - Business Model
Mortgage REITs (mREITs) derive their income from the interest spread - the difference between the interest rate they get from their investments and the interest they pay on their loans and liabilities. When long-term interest rates fall, it has a direct impact on their earnings. Since agency MBS have a fixed rate and are usually acquired at a premium, they are affected more than REITs that invest in non-agency MBS, which have adjustable interest rates and are acquired at a discount.
Performance - The Month Gone By and Future Outlook
REITs have been among the most attractive and recommended stocks in the past due to their high dividend yields and scope for appreciation. However, the quantitative easing measures for bringing down interest rates dealt a blow to their income source.
Lowering of long-term interest rates has been one of the reasons why REITs have been relatively lackluster this month in the stock market. One-month price chart of major REITs looks like this - each one of them, including Vanguard REIT ETF (VTR) and large cap mortgage REITs like American Capital (AGNC) and Armour (ARR), is heading south.
The third round of quantitative easing deals yet another blow to agency mREITs. The Federal Reserve announced that it intends to buy agency mortgage-backed securities worth $40 billion every month, a move that has caused the interest spread to fall further.
Much of the above would have been playing heavy on Annaly's management team when it offered to acquire CreXus. The acquisition is being viewed as recognition and acceptance that the agency mREIT business model cannot sustain in the present environment.
The move by Annaly is an attempt to diversify its assets as the Fed's move to speed up purchase of agency mortgage-backed securities is bound to further bring down long-term interest rates and affect profitability of agency mREITs and their ability to maintain dividend payouts at previous levels.
Annaly is bound by its investment policy that at least 75% of its assets consist of agency mortgage-backed securities and short-term investments. Only the remaining 25% may comprise of other qualified REIT real estate assets. CreXus, on the other side, is a commercial real estate investment trust that invests primarily in commercial mortgage loans and commercial real estate debt. It may also acquire real commercial properties along with investing in agency residential mortgage-backed securities.
Annaly's acquisition of CreXus will help in improving its net interest rate spread which fell by 100 basis points to 1.02% in the third quarter 2012. In contrast, being primarily a non-agency REIT, CXS had a net interest margin of 10.4%.
What Should Investors Do?
At $12.5 per share, NLY has put CreXus' value at $957.5 million. Since it already owns 12.4% shares it needs to pay only $839 million. Annaly's revenue in third quarter 2012 was $3.6 billion, which implies that it has adequate resources to pay for the acquisition. The acquisition will ease the pressure on the company's net interest margin and may well halt the downward slide of Annaly's stock price.
A minor hurdle is being presented by investigations by a civil litigation firm as to whether or not the management of CreXus violated the trust of shareholders while valuing the company. It must be kept in mind that "each CreXus' officer also serves as an employee of Annaly or FIDAC".
Besides, Annaly is committed to lowering its cost of capital through the issue of preference shares and convertible notes worth $1.5 billion. In my opinion, long term investors stand to gain by investing Annaly stock at its current price.