Reasons Why Annaly And Some Other REITs Should Continue To Do Well

| About: Annaly Capital (NLY)

by Kathleen Martin

There has been talk in the blogsphere about a coming panic in the REIT market. Are we getting to a point in the economic cycle where we are more optimistic and certain of a recovery? Good question. REITs have been a great investment in this low interest rate market. Specifically, REITs that invest in Agency guaranteed paper have provided consistent dividends through solid portfolio management by internal managers. Investors are not necessarily jumping into these stocks for capital appreciation.

Dividends have been cut in the case of Annaly (NYSE:NLY), Chimera (NYSE:CIM), and Equity Residential (NYSE:EQR) since 2009. Only Equity Residential saw a dividend increase in one quarter of 2011. Annaly, when compared to its peers, has offered a high dividend yield. This is primarily due to its investment strategy, its trading program, and the competence of its management in times of crisis in the capital markets. Annaly has been a great port in the storm that has been the capital markets. Is Annaly a good investment for the future?

Annaly's common shares trade around $16, and have a 52-week range between $14.05 and $18.79. It has a price earnings ratio of 29.86, earnings per share of $0.56, and a dividend yield of 13.30%. Annaly has total cash of $4.6 billion and total debt of $95.3 billion. Its book value per share is $16.18. Market capitalization is currently at $16.24 billion.

Annaly recently announced the pricing of its public offering of 11 million shares of Preferred C 7.635% at $25 per share for gross proceeds of approximately $275 million. The use of proceeds is to purchase mortgage backed securities for its investment portfolio and for general corporate purposes, which may include retirement of some of its long- term debt. The fact that the company was able to fully finance a preferred issue that pays less of a dividend than the common stock signals that the market is wary of interest rate promises and prepared to bet on a long-term, steady rate.

I have said before, this stock is going to stay low and may still go lower. Prolonged low interest rates and diminished returns from thin trading margins are going to mean less money to distribute to shareholders. The dividend on the common shares has decreased steadily since 2009 and will continue to do so. That said, Annaly still offers great liquidity and it pays a relatively high dividend.

Moody's Investor Services provided a stable outlook on U.S. REITs in January 2012. One of the reasons for the rating is that Moody's believes that most investment grade rated trust will keep dividend payouts low relative to funds available for distribution. I don't really understand this rationale as REITs have to distribute 90% of net income to maintain tax favored status. In January, Moody's felt that the capital markets had stabilized to the extent that capital became available to REITs with strong balance sheets. This has proven to be true in the case of Annaly.

Investors have shown confidence in the REIT market because those REITs that invest in Agency backed paper have outperformed the overall REIT market in recent years. If the Federal Reserve expects that interest rates will remain low until late 2014, investment in REITs that hold Agency backed mortgage securities will remain positive.

One company that will continue to benefit from low rates and the prolonged recovery process is AvalonBay Communities (NYSE:AVB). This REIT develops apartment complexes in wealthy, usually gated communities in upscale markets such as Washington DC, Manhattan and San Francisco. In these areas, renting is still less expensive than buying, even with declines in home prices. The company reported net income of $0.60 per share for the first quarter 2012 compared with $0.35 per share for the first quarter of 2011. The increase is due to a jump in operating income from existing and newly developed and acquired properties and reduced interest expense. This company actually has direct and indirect ownership interest in 199 properties as well as 20 properties under construction and 10 under re-construction. The risk in this investment is its exposure to development risks of time delays, financing costs and lending rate fluctuations.

Companies like Capstead Mortgage (NYSE:CMO), which focus on Adjustable Rate Mortgages (ARM), are Agency guaranteed and well positioned for economic recovery. Capstead's relative lack of credit risk shields the company from volatility. The adjustable rate features reduce fluctuations in value due to changes in interest rates. The coupon rate adjusts and can go higher when interest rates rise, allowing for better retention of value than fixed rate mortgage loan portfolios. Capstead is not concerned with the credit risk side of the business. It is Capstead's job to manage the interest rate risk. Its portfolio is heavily weighted in ARM securities that will have rate resets within 18 months. The balance, around 30% of the portfolio, will reset within five years.

Commercial REITs that invest outside of the U.S are betting on recovery and growth in international markets to provide returns to investors. If you are an optimist and believe that recovery is a possible event rather than a process, foreign commercial REITs are worth a look. When expanding into strategic international markets, U.S. REITs can minimize risk, providing income and growth. Portfolio diversification into foreign markets allows the balancing of geographical risk and enhances returns by entering markets that have expanding wealth, increasing purchasing power and relatively little competition. While macro-economic issues will always be a factor to REITs and their portfolios, the well managed REITs will perform well when the recovery actually happens.

Kimco Realty (NYSE:KIM) has a large portfolio of commercial properties in Latin America and Canada. Its portfolio holdings are taking advantage of the growing middle class in Latin America, which is increasing demand for consumer products and services. Kimco has a portfolio of 55 shopping centers with anchor tenants such as grocers and cinema operators.

Taubman Centers (NYSE:TCO), the highly successful commercial REIT, went into the Asian market in 2005, and has a mall property opening in South Korea in late 2012. Simon Property Group (NYSE:SPG) formed a partnership with Mitsubishi Estate to construct a Premium Outlet Center in Japan. Simon has 57 Premium Outlets in the U.S., one in Puerto Rico, eight in Japan, two in Korea, and one each in Mexico and Malaysia. It also acquired a 30% equity stake in listed French REIT Klepierre, which has an interest in 270 shopping centers in 13 European countries that will take advantage of any upturn in the European economy. Simon also has retail properties in Poland, Italy, and China. Prologis (NYSE:PLD) is the world's largest landlord of industrial distribution facilities, having a presence in Europe and Asia. It leases distribution facilities to manufacturers, retailers, transportation companies and other enterprises.

Cousins Properties (NYSE:CUZ) has a domestic commercial portfolio that has a large development component. The development component increases risk for investors as exposure to credit constraints, costs and delays. In addition, the company generates a large portion of its revenue from leasing its office portfolio. If job losses continue, revenues will decrease from this sector of the portfolio.

The Federal Reserve has forecast that the economy will grow between 2.4 and 2.9% in 2012. It predicts unemployment numbers will range from 7.8% to 8% (currently 8.1%). The Fed sees inflation slightly higher in 2012 but below the set target of 2%. The Fed is still expecting interest rates to remain low until 2014. The Federal Reserve has also stated that if needed, it will employ a third round of quantitative easing to boost the economy. A depressed housing market and lack of a consensus on the national debt reduction are two main drawbacks to recovery. Low short-term rates have been the primary reason for yields on residential mortgage REITs. Any rate hike above what is anticipated will diminish the yields that Annaly has been able to achieve with its portfolio of residential paper.

One big risk in the mortgage REIT sector is that any kind of reform in the home mortgage market will mean that the amount of securities the Agencies will issue in the future will decline. Less available paper means that some of these residential REITs will have less access to guaranteed paper and will have to manage both credit and interest rate risk.

Central bankers are now saying that a little bit of inflation would be a good thing. This is cause for concern. We know that unless there is something catastrophic, rates won't increase in 2012. But I believe that the powers that be are re-thinking keeping the rates low into 2014. While the idea in theory is that inflation will stimulate the economy by decreasing the value of mortgage debt, it is really a sleight of hand maneuver based on optics which would trick the eye into thinking the economy would be on the road to recovery.

REITs that have delivered consistent dividends, demonstrated corporate transparency through performance based compensation, and internal management of portfolios are well regarded as investment vehicles. Investors who are confident in foreign markets have several options to explore. Investors who want the security of investing close to home have many options. Annaly is still one of the better ones. In any event, it comes down to the ability of the portfolio managers to adjust holdings to macro-economic conditions. Annaly has proven its strength by delivering dividends since its inception in 1997.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.