Around 7 months ago, I said what the bulls never want to hear - namely, that Annaly Capital (NLY) and Chimera Investment (CIM) were "too good to be true". The piece was universally panned, but I expected it given the cult crowds that surround these high-risk mortgage REITs. At a time when the housing market is uncertain, I argued, that low interest rates would not be enough to justify the current valuation, let alone price appreciation. A few dividend cuts and Fed announcements later, and the two stocks have drastically underperformed. While Annaly gained just half of the S&P 500, Chimera actually fell 14.9%.
Fortunately, the comments indicated increasing agreement with my bearish sentiment as the stocks tumbled. At his point, Annaly and Chimera are both rated closer to a "sell" than a "buy" with price targets nominally higher than the prevailing price. In my view, the short thesis is unwarranted. Here's why: While job figures have been disappointing (to say the least), the global economy is heading in the right direction. At the same time, the Fed has committed itself to low interest rates under macro uncertainty. This leaves mREITs with the best of both worlds: growing demand and low interest rates. Substantial risk from US Dollar Funding may make conditions more adverse for mortgage securities as LIBOR rises, but a quicker-than-expected recovery will more than mask the effect.
As it stands, Annaly and Chimera are risky but not overvalued. The former is expected to have 2012 EPS of $2.05 and then grow 3% annually thereafter. That means $2.31 EPS by 2016, which, at a 12x multiple, translates to a future stock value of $27.68. A generous 10% discount rate would put the price target at $17.19. This is nominally higher than the current market price but comes on top of a 13% dividend yield. Chimera is expected to have 2012 EPS of $0.45 and then grow 2.5% annually thereafter. That means $0.50 EPS by 2016, which, at a 12x multiple, translates to a future stock value of $5.96. A generous 10% discount rate would put the price target at $3.70. This is 55% higher than the current price and comes on top of a 15% dividend yield.
Accordingly, in my view, Chimera comes with more value than Annaly. It trades at 27% below book value versus 4% above book value for its sister company. This view stands in contrasts to the Street's. In any event, opening a short position in either company is simply not worth the headache or risk. Both firms are highly cyclical and volatile, so the stock could head in one direction without notice. But the downside case appears to be more limited than the upside case at this point given how managements of both firms have slashed dividend distributions as shareholder value has fallen.
Risk will always be inherent in real estate equities, but this helps drive stronger returns according to financial theory. Equity Residential (EQR) is another REIT that has a high risk / high reward profile. The firm is currently valued at a low 5% cap rate, which is promising given strong growth prospects. Vornado Realty Trust (VNO) has outperformed the S&P 500 over the last six months with a nearly 10% return. It is highly volatile at a 1.6 beta and risky after shaky performance. 2Q11, 3Q11, and 1Q12 might have beaten expectations, but the 1Q11 10.2% miss and 4Q11 5.7% miss will keep investors on the sidelines. Shaky performance comes on top of expectations for shrinking EPS over the next two years. Since there is considerable volatility in the sector, investors are encouraged to broadly diversify across REITs and not get hooked up in one potential "winner". This means mild long exposure to Annaly and Chimera should be complemented with other real estate investments.