There is a popular saying that you should never catch a falling knife. Human nature is such that ones first instinct when dropping something is to quickly reach out to prevent it from hitting the ground and possibly breaking. Or in some cases, preventing the falling object from landing on your foot. In the case of knives, the reason not to try to catch it are obvious, but too often we forget this rule when we are considering investing in a particular stock.
Take Annaly Capital Management (NYSE:NLY) for example. From an April high of about 15, the stock of the mortgage REIT has dropped over 30% and recently traded below 10. We know plenty of investors that tried to catch this falling knife at 12 on two separate occasions only to see the stock continue to fall. At a recent price of $10.10, we think it might be time to take a closer look and determine if it has truly hit bottom.
Annaly Capital Management
Annaly is the largest mortgage REIT by market capitalization. It owns, manages, and finances real estate related investments, including a variety of securities, including: mortgages, mortgage pass-through certificates, collateralized mortgage obligations, agency debentures, and other securities. If you are wondering where the funds came from for your recent mortgage, there is a good chance it came from a company like Annaly.
Annaly, like other mortgage REITs, make money by purchasing mortgages in the secondary market and collecting the principal and interest payments from these mortgages. They finance these purchases through short-term borrowing and can be in a variety of forms, such as swaps, repurchase agreements, (often referred to as repos), or swaptions. For simplification, we will simply refer to all of these financing sources as short-term borrowing.
Typically, if the interest rate on the mortgages purchased is greater than the interest rate on the loans, the mortgage REIT will earn a spread. But the mortgage REIT business model doesn't end there. Once the mortgages are purchased, they become assets on the balance sheet and are available as collateral for additional borrowing, which leads to additional purchases of mortgages, etc. It is not surprising for a mortgage REIT to be leveraged 10 times or more. A net margin of 1.5%, therefore, can be leveraged to provide a gross yield of 15% if leveraged 10 times. If you haven't noticed already, mortgage REITs pay a very high dividend, usually in the mid-teens.
Unfortunately, there is no such thing as a free lunch. Investing in mortgage REITs exposes investors to certain risks, which make mortgage REITs quite a bit more volatile than REITs operating in other sectors, such as Senior Housing Trust (NYSE:SNH) or Ventas (NYSE:VTR).
We are probably at the end or near the end of the mortgage default debacle that has plagued the industry and our economy for several years. But even in the event that we experience another 2008-like year and borrowers either involuntary default, or as is often the case these days, decide not to pay their mortgage, all of the mortgage securities on the Annaly balance sheet are guaranteed by either Fannie Mae, Freddie Mac, or Ginnie Mae, government backed agencies created to provide resources for mortgage lending. That effectively makes these securities default-free with an implied rating of AA+ -- a couple of steps above their target of an S&P rating of A. So at least in the case of Annaly, this risk is somewhat mitigated.
Interest Rate Changes
When interest rates rise, mortgage REITs are affected in two distinct ways. On the one hand, the value of the securities they hold, namely the mortgages, typically fall in value with interest rates rise. They have the same reaction as does the fixed income space in general. Secondly, depending on whether short rates or long rates are rising, the cost of borrowing can increase rapidly when short term rates rise. This has a negative effect on the spread between the interest received from the mortgages and the interest paid on the short-term loans. The mortgage REIT must either decrease the dividend or increase leverage to maintain the same dividend. Investors will not be pleased with the first option and the second option makes the investment even riskier.
With the recent announcement by the FED that $10 billion in tapering will begin in January, there is at least a bit less uncertainty going forward. The mortgage REITs, including Annaly, can now plan accordingly.
Prepayment risk is highest in an environment of decreasing dividends. We have just lived through such an environment, and there have been some clear winners and losers in the refinancing boom. But interest rates are quite possibly at all-time lows, and while there may still be some borrowers out there thinking about refinancing, the majority that qualified for refinancing, have already done so. In fact, prepayment rates for Annaly have dropped considerably each quarter. See chart.
In the event that any of these risks cause the value of the securities it holds to decrease in value by a large enough amounts, Annaly would then have to sell some of these securities at the lower price in order to meet margin calls. This process can feed itself. As securities are sold to meet margin call, driving the prices down, the lower prices trigger additional margin calls, which leads to additional sales, and so on.
Annaly Change in Strategy
We like Annaly for a couple of reasons. One, it has slowly migrated its portfolio from strictly residential mortgages to commercial real estate loans. These commercial real estate loans have a higher yield than mortgages with shorter duration and are less sensitive to an eventual FED tapering. Commercial real estate (CRE) loans make up only $1.3 billion of an $84 billion portfolio but management intends on growing this portfolio to $2 billion by year end and 25% of its equity over the longer term.
We see this as a positive trend as commercial real estate offers better risk-adjusted returns than mortgages. A recent survey by the Federal Reserve shows strong demand for commercial real estate loans and Annaly has a war chest of cash available to deploy into the space. Our biggest concern with the strategy is that Annaly is new to the space and does not have either a real estate footprint or the institutional relationships that other commercial mortgage REITS enjoy. Regardless, we feel confident in Annaly's ability to shift its strategy and of all the other mortgage REITs, it certainly has the resources to be a formidable player.
Why Invest Now
We are watching the stock price movement closely for a strong sign that the stock has hit bottom. Regardless, we are inching our way into positions even at these levels. We like the stock for a variety of reasons:
1. Dividend yield - Annaly has reduced its dividend from $1.60 per share to an estimated $1.15 per share. This still implies a dividend yield of 11.6%.
2. Net spread widened for the first time in a long time - As the chart below shows, net interest spread increased from $0.98 to $1.01, primarily due to an increase in the average yield on interest earning assets.
3. Rates may rise slower and/or expectations are discounted - the rapid rise in rates over the Summer of 2013 is not likely to happen again. We expect rates to rise but at a more moderate pace, making portfolio adjustments easier to manage.
4. Largest mREIT - Annaly is the largest mortgage REIT and one of the best managed. If any of the mREITs can navigate a difficult environment, our money is with Annaly.
5. The shift into commercial real estate, while increasing execution risk, may open up an entire new investment universe for Annaly.
6. Annaly's core earnings, which have been falling dramatically, may have finally stabilized at $0.28/per share for the quarter ending September 30th. Keep in mind that because Annaly does not have any depreciation or amortization, this would be the equivalent of funds from operations for most other REITs. If the $0.28 were annualized, Annaly can be thought to be trading at less than 9 times FFO. That seems to be a compelling entry point.
Generally speaking, the mortgage REITs are more volatile and more sensitive to interest rate risk than most other REITs. But at this juncture in the economic environment, they may be worth consideration again.
Disclosure: I am long NLY, SNH, VTR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.