On Januray 31, Annaly Capital Management Inc. (NLY), the largest mortgage real estate investment trust, or mREIT, reported that it agreed to purchase the rest of Crexus Investment Corp. (CXS) for about $872 million. Annaly already owns 12.4 percent of Crexus and will pay $13 per share in cash for the remaining stock, valuing the company at $996 million. The terms of the agreement allow Crexus to pursue alternatives to the deal though March 16, and Cerxus has indicated that a special committee and independent advisers will "actively solicit" other options.
In November, Annaly bid $12.50 a share for CXS, a commercial mREIT as part of Annaly's new plan to broaden its business in the wake of Federal Reserve purchases of government-backed residential mortgage debt, which have caused agency security yields to decline and prepayment rates to increase. Annaly is an agency mREIT that primarily holds agency-backed mortgage paper issued by Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), ad well as related securities, but the culmination of this deal would mark the end of Annaly's agency-only era.
Crexus and Annaly have prior relations. Beyond Analy's 12.4 percent ownership of Crexus, the commercial mREIT is managed by FIDAC, a wholly owned subsidiary of Annaly. As a result, Annaly is clearly highly familiar with the assets held within the Crexus portfolio. At the time Annaly made its initial bid for Crexus, Wellington Denahan, Annaly's 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 multiply the spread, or margin, between their borrowing costs and the yield paid by the portfolio. Narrowing spreads generally makes this practice less profitable and/or require higher leverage, which would bring with it higher corresponding risk.
Rather than further leverage up with agency debt at a time where rates are at or near historic lows, 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. This is a fairly bold move that may alienate the large agency mREIT from some of its investors, including some institutional holders, though such is yet to be seen.
The CMBSs that Crexus holds generally carry higher yields than agency-backed RMBSs because they are not considered default-proof, while agency paper is deemed essentially default-proof. 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. Annaly's management initially formed Crexus to capitalize on that decline in CMBSs.
It is also entirely possible and rather likely that Annaly will also add non-agency RMBSs to its portfolio, though such is no certainty. Annaly indicated that it may allocate as much as 25 percent of its equity into assets other than Agency RMBSs, making other and further acquisitions entirely possible. Chimera (CIM), a non-agency mREIT in which Annaly also owns an interest and that is also managed by FIDAC, may be another potential acquisition target for Annaly, and especially if Annaly is interested in gaining exposure to non-agency RMBSs. Chimera also holds a decent amount of agency RMBSs like those that Annaly traditionally holds.
Chimera's shares have been volatile over the last 12 months due to accounting issues, but appreciated by about 8 percent in response to the initial Crexus offer announcement. Chimera also appreciated by about 2.5 percent in response to this most recent deal news, and on a day where most other mortgage REITs are down.
Chimera has had a difficult last several quarters. In addition to constantly postponing filings, CIM has also reduced 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 subsequent quarterly payouts would 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 the largest mREIT, but has underperformed some of its newer rivals such as American Capital Agency Corp. (AGNC) over the last several 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, but such leveraged bets look extremely risky in the current market.
Now, most agency mREITs are primarily concerned with being forced out of their agency security holdings due to rising prepayments, and both NLY and AGNC are repurchasing shares rather than buying new securities. If declining spreads and rising prepayments continue, dividend cuts appear inevitable across the agency mREIT space in 2013 and some other agency mREITs will likely either follow Annaly out of the asset class or choose to further leverage up.
REITs must pay out 90% of income in order to avoid paying corporate taxes, but those dividends are taxed as income to the recipient and not at a lower qualified dividend rate like a standard corporate dividend. As a result, investors often prefer to hold mREITs in tax-sheltered accounts like an IRA, where the higher tax-rate is less of a concern.