- Company can increase core EPS by terminating position in short duration swaps.
- Initiative to increase commercial real estate exposure will portend well for future performance.
- Company has been transforming itself into a hybrid mREIT model.
- The stock deserves valuation premium in comparison to agency mREITs.
Rate volatility adversely affected net spreads earned and book values of mREITs in 2013. However, I believe the rate volatility will reduce going forward, which will benefit mREITs and boost their performance. Also, a systematic end to the Fed's asset purchase and an unchanged Federal Funds rate until 2H2015 will portend well for mREITs' book values. I am bullish on Annaly Capital Management (NYSE:NLY), as the company offers an impressive dividend yield of 10.30%. Also, the company has been increasing its exposure to commercial residential, which will improve the company's risk profile and earnings, as it offers a better yield than other MBS investments. Moreover, I believe the company could improve its core EPS and make dividends stable by terminating a significant portion of the $24 billion (notional) short duration swaps.
Core EPS for NLY came out to be $0.23 in 1Q14, missing consensus estimates of $0.28 per share. Earnings for the quarter were adversely affected by a lower interest rate spread, which was down 0.24% quarter-on-quarter to 0.94%, mainly due to a 0.29% quarter-on-quarter drop in earnings yields and funding cost rising by 0.24% to 2.31%. Also in 1Q14, the company extended its weighted average swap maturity to 5.31 years from 5.26 years. The company has one of the lowest leverages in the mREITs' space, regardless of the fact that the company's leverage increased to 5.2x in 1Q14, up from 5.0x in 4Q13. Low leverage allows NLY to be opportunistic with capital allocation according to the rate environment; when the spread widens the company could increase leverage, which will positively affect its earnings.
Another tool the company can use to grow its core EPS above its current quarterly dividend of $0.30 per share is changing its portfolio. As short-term rates are unlikely to change enough in the near term, the company has an option to terminate a large portion of the $24 billion (notional) short duration (0-3 years), out of the money swaps. NLY can terminate the swaps by paying the counter parties the net present value of future cash flows instead of paying a monthly fixed rate over the next 24 months; the company is currently paying 1.78% fixed on these short duration swaps. If the company decides to completely terminate its swaps position of $24 billion (notional), it will positively impact NLY's core EPS by approximately $0.10 over the next 8 quarters, as interest costs associated with swaps would be saved.
I believe that terminating the short duration swaps will positively affect the company's performance, as the company will be able to deploy where there are better return opportunities. The strategy will also increase dividend sustainability, as dividends will be supported by core EPS. Currently, the stock offers an impressive dividend yield of 10.30%. As NLY will reposition and resize this sort duration swaps exposure, it will improve net asset spread in the future.
Moreover, increasing exposure to the commercial mortgage business is an attractive initiative, which the company is taking to improve net asset spread. Commercial mortgage offers a better yield than other MBS. The company has a liquid balance sheet, which supports the initiative and gives competitive advantage. In 1Q14, the total CRE investment portfolio increased to $1.7 billion, up 4.5% quarter-on-quarter. Commercial investments by NLY represent approximately 12% of its equity, which the company plans to increase to 25%. Earlier this week, NLY announced a net lease initiative with the Inland Real Estate Group, which will help it acquire leased commercial real estate in several industries and markets, including office, industrial, restaurant and retail properties.
Valuation and Conclusion
As NLY increases its portfolio allocation and exposure to commercial real estate, it looks like more of a hybrid mREIT instead of a pure-play agency mREIT. Therefore, I believe the stock should trade more like a hybrid mREIT, and deserve valuation premium in comparison to agency mREITs. The stock is trading at a discount in comparison to hybrid mREITs, as shown in the table below; NLY is trading at a price-to-book value of 0.91x, as compared to its peers' average of 0.95x.
AG Mortgage Investment (NYSE:MITT)
Two Harbors (NYSE:TWO)
Invesco Mortgage (NYSE:IVR)
MFA Financial, Inc. (NYSE:MFA)
Dynex Capital Inc. (NYSE:DX)
Price to Book Value
The company can increase its core EPS by terminating its position in short duration swaps, which will increase its dividend sustainability. Also, the company's initiative to increase commercial real estate exposure will portend well for the company's future performance. As, with time, the company has been transforming itself more into a hybrid mREIT model, I believe the stock deserves valuation premium in comparison to agency mREITs, and NLY's current valuations remain attractive.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.