Investing in real estate can be difficult and investing in mortgage securities nearly impossible for an individual investor. Through a change in the tax code in 1986, Real Estate Investment Trusts ("REITs") were created within the United States to make it easier for individuals to invest in real estate. REITs are essentially securities of companies in the real estate space that are required to payout 90% of their income as dividends. For novice investors the type that likely comes to mind are REITs that purchase hard assets such as hotels, shopping centers and the like. Although these REITs exist, there is also a smaller universe of so called mortgage REITs. These entities generally invest in either residential or commercial mortgage securities. Annaly Capital Management (NLY) is one of the larger pure play mortgage REITs. The low interest rate environment has reduced its net interest income stream, but the company may be one of the best positioned mortgage REITs should interest rates rise and interest spreads widen.
Annaly was founded in 1997 to invest in residential mortgages. With the explosion of securitizations in 1990s and 2000s, most of Annaly's investments pass through residential mortgage backed securities ("RMBS") or more structured products like collateralized mortgage obligations ("CMO"). The company maintains a fairly strict investment policy, which requires it to have 75% of its investments in high grade mortgage backed securities. The company purchases mostly government guaranteed mortgage assets, which results in minimal credit risk. Unfortunately, the low interest rates over the last three years have severely impacted net income as the table below shows.
(dollars in thousands)
Net Income Applicable to Common Equity
As the company is required to payout 90% of its earnings as dividends, its ability to build retained earnings is limited. The company has used the relative buoyancy of equity markets over the last two years to issue equity and reduce its financial leverage.
(dollars in thousands)
Assets to Equity
Additionally, Annaly converted preferred shares into common equity during the early part of 2012. The company appears to be well-positioned to increase leverage should yield spreads widen, but there are limited opportunities currently available for Annaly to invest in. I believe that Annaly's discipline is shown by its election to reduce its leverage rather to make sub-par investments. The company likely faces continued downward pressure on its ability to maintain its dividend yield. The reason is simply that as higher yielding fixed rate mortgages roll off they are replaced with lower yielding mortgages thus decreasing Annaly's net interest margin unless there is a corresponding decrease in funding costs. As most of Annaly's funding is variable rate (hedged by swaps) there is almost no room for declines in funding costs given the historically low level for the yield on Treasury securities.
Annaly's 2011 10-K indicates the company would experience an 8.47% decline in economic net interest margin should rates rise by 75 basis points. Additionally, the company indicates the value of its portfolio would increase by 12 basis points. This figure is somewhat misleading as it is based on an instantaneous parallel shift of the yield curve. This is highly unlikely to occur and it may fail to capture the longer term positive impacts that higher rates may have on the company. Additionally, Annaly does not disclose the dollar impact of these changes, which is unfortunate. Estimating the dollar impact on my own, I believe the net dollar change of both value and income change to be roughly zero. Although the income impact is offset by the value change, the actual cash impact is likely negative as the company may be unwilling to sell securities to make up the lost net interest income. Although I believe the dividend yield is likely to continue to decline in 2012, the longer term prospects are brighter as the housing industry rebounds, mortgage rates begin a climb back to historical norms, and Annaly leverages its balance sheet back up to capture these higher yielding opportunities.
Annaly is a large purchaser of mortgage securities. Due to the near death experience of private label CMOs, securities either directly issued by or back-stopped by Fannie Mae, Freddie Mac and Ginnie Mae are about the only supply currently available. Annaly must compete for these securities against not only other mortgage REITs, but mutual funds, commercial banks, insurance companies and even foreign governments which are all eager to purchase federally insured fixed income products.
Within the residential mortgage REIT space, Annaly is the largest player by market capitalization with a recent value of nearly $16 billion. American Capital Agency (AGNC) has a similar business model to Annaly in that it purchases securities guaranteed by one of the federal mortgage agencies. American Capital maintained a higher leverage ratio of 9.33 times at 12/31/11 compared to Annaly's relatively low 6.96 times. Neither ratio is particularly worrisome, but is telling of each company's relative view on current opportunities.
A significantly smaller competitor is Capstead Mortgage (CMO) with a recent market capitalization of $1.25 billion. Capstead maintains a leverage ratio at 12/31/11 in excess of 10 times. Capstead like American Capital invests primarily in agency securities that limit the credit risk on the investment portfolio. Capstead's net interest margin was 1.56% versus Annaly's 2.09% for the year ended 2011. Hedging cost and investment gain/losses are fall below net interest income. Capstead shows a net margin of 66% versus Annaly's 9.62%. The difference is actually much closer, but Annaly elects to show most hedging losses in the income statement versus Capstead, which amortizes these losses via other comprehensive income. I believe that Annaly uses a truer and more conservative accounting methodology, which is more shareholder friendly.
The potential changes associated with Basel III have caused banks to increase their liquid securities holding. Agency mortgage securities are highly liquid and yield slightly more than Treasuries making them attractive to the banks. This demand has placed downward pressure on yield and thus profitability, but banks like Wells Fargo (WFC) and Regions Financial (RF) continue to buy due to regulatory needs.
Financial companies do not lend themselves easily to discounted cash flow models. In theory, the direct equity method should be the recommended approach. However, theory rarely holds. For the direct equity method to work financial business would need to fair value their entire balance sheet, which remains a controversial idea among CFOs of financial institutions. This requires us to take more indirect approaches to reaching an opinion on the value of Annaly Capital.
The first approach we will use is tangible book. Currently, I estimated Annaly's tangible book per share using 2011 year end results to be approximately $16.20 per share. This approach subtracts out the accumulated deficit and adds back the gain in other comprehensive income. I believe a reasonable premium to book value is to simply ignore the accumulated deficit, which represents cash paid to shareholders in excess of earnings. Any purchase of Annaly's business or assets will likely ignore this deficit. This approach provides an estimated value per share of $18.50.
Ultimately, the purchase of equity in Annaly is a dividend investment with limited opportunity for potential capital appreciation. This leads to a discounted dividend model as an appropriate method to value the business. Assuming a rough cost of equity of 13.75%, a perpetuity growth rate of 2.5% and a next year dividend yield of 12.20% I estimated fair value at $17.60.
Annaly's balance sheet is financed with secured debt that requires periodic rollovers. If Annaly is unable to roll the debt or is required to post additional collateral to do so, then the company could find its liquidity impaired. A sustained period of low interest rates increases the likelihood that the company will not be able to maintain its dividend yield at current levels, although a positive spread supporting some level of dividend payments remains highly probable. Lastly, the company operates in the capital markets and needs a steady supply of mortgage securities to replace prepayments. The future of Fannie Mae and Freddie Mac remain in doubt and could impede Annaly's long term prospects.
My opinion is that Annaly remains one of the best managed mortgage REITs in the business and it has restructured its balance sheet to be in position to capitalize on interest rates and home buying once the market returns to more normalized levels. In the intermediate term, the dividend yield will likely suffer and in the long term will likely grow at the rate of the overall economy. Margin of safety is always important to consider and I believe that a 10% margin is reasonable for Annaly and its conservative approach. My range of fair value is relatively tight at $16.20 on the low end and $18.50 at the high end. Using the mid-point fair value of value $17.35, then a reasonable entry point is $15.61.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.