Jan Brzeski

Value
Jan Brzeski
Value
Contributor since: 2011
Company: Arixa Capital Advisors, LLC
Jonk, you and I are saying different things. You are saying "this stock delivered great returns over the past year". From a quick look, I see NLY is priced almost exactly where it was a year ago, and the dividend seems to be down a little, but not much. True, a double-digit dividend yield is nothing to sneeze at.
My articles on NLY aimed to analyze how the company makes money. My guess is lots of smaller investors who own the stock don't really understand how the business works. By all accounts there is real risk of capital loss with this stock. The fact that the relationship between NLY's short term borrowing costs and longer-maturity Agency bond yields remained favorable for the past year doesn't change the fact that the relationship could change at any time. In this respect, owning NLY is very different from, say, owning a portfolio of well-underwritten real estate loans, without using leverage.
To address a few of your comments directly, you are correct that I don't own NLY (or any other MREITs). Instead, I run a private mortgage fund, so I do understand how the mortgage business works. We've made money on almost 100 loan investments in the past three years, without ever losing money on an investment. Clearly, there are multiple valid ways to make money in this market.
The analysis in this article is not deep or very insightful, in my view. The methodology very simplistic. It should come as no surprise that all three companies that came up using the screening technique are the the same business--buying Fannie, Freddie and/or Ginnie Mae bonds with medium maturities, and then leveraging up using very short term cheap debt (also known as "crack cocaine debt"). As I have explained in some of my articles about Annaly Capital, there is a real risk of substantial capital loss if and when short term borrowing rates go up. The whole idea of investing in medium-maturity fixed income and leveraging that bet with much shorter term financing is a form of gambling, in my view. Investing in this strategy is basically a way of collecting far-above-market current income by taking substantial risk of capital loss. There is minimal real value created by these companies. Anybody could buy government-guaranteed bonds and leverage them up with short term debt.
Thank you Newar, you are right, I was referring to EQR and typed EQU by mistake. I have contacted SA to request whether they can make this correction.
Hawkins, thank you for your comment. Are you able to quantify your contention that rents on the highest quality assets have held steadier than rents on lower quality assets? This may well be the case but the hypothesis needs to be tested against facts in some ways. One way to estimate the change in rents on high quality properties is to look at "same store sales" gains and losses reported by many REITs. Although I have not done the work to prove it, my sense is that the huge run-up in values of REIT-quality assets has taken place against a backdrop of fairly flat revenue in all asset classes. Property income dropped a few years ago and has been pretty flat since, in my experience.
Bryce, I enjoyed your article. It was a nice, simple introduction to Penny Mac.
Personally, I would like to see you publish more articles on the company. Providing more in-depth plain-spoken descriptions of how the business makes money would be particularly valuable.
For example, you mention the dividend is 12.75%. I assume the underlying yield on the mortgages owned by PMT is in the mid single digits. If the company is buying mortgages at, say, 60 cents on the dollar, then how are they achieving such a high yield? There must be some "capital gains" flowing into their numbers because interest payments alone would not lead to this kind of yield (unless they were using leverage, which you have indicated that they do not use).
Also, I would like to know more about how management is compensated. In addition, Patrick made some very specific comments. I would like to see those addressed, not necessarily with more comments, but with a follow up article using analysis gleaned from PMT's SEC filings to address the issues he raises, among others.
That is my wish list, for what it is worth! Articles like yours demonstrate the value that Seeking Alpha can provide. Without the need for Wall Street lingo and polish, analysts like you can help us get to the heart of what is going on. PMT looks like an interesting business...I just want to know more about how they really make money and how risky or not risky their income stream is as a result.
Rallkl, in the case of Annaly, the interest rate they earn is the yield on their portfolio of Fannie Mae, Freddie Mac and Ginnie Mae bonds (collectively known as "Agency" bonds). The weighted average maturity of these bonds appears to be about 5 years, from the financial statements I reviewed for this article. The interest rate the Annaly pays on its debts is the rate charged by banks who lend to Annaly on a short-term basis.
The amount of spread that Annaly earns is a function of two different factors. First, Annaly is borrowing "short" and lending "long", taking advantage of the fact that the yield curve slopes up. Second, it is taking advantage of the fact that lenders to Annaly view their loans as very secure, since Annaly has billions of dollars of shareholders' equity to back up the loans, in addition to having the Agency bonds as security.
Government policy does affect the spread, because the Fed sets certain important interest rates, however the Government does not directly control either Annaly's borrowing costs or its yield on the Agency bonds. As an example, the rate of interest that Greek banks need to pay today has spiked. The Greek government would like the rate to be lower, but things have gotten to the point there that the Government has little control over these rates.
Thomas, thanks for your comment. You demonstrate detailed knowledge of the business that goes beyond my knowledge.
My objective with this article was to explain to amateur investors who are enticed by the high dividend of NLY how the company's business model works. This may be common knowledge to most investors holding NLY in their portfolio, but I still think there is some benefit to making sure people who haven't gone through the numbers understand the basic business model. Your comment is compelling but it doesn't change the key point of my article about risks inherent in the business model of companies like NLY.
Regarding the risk that rates of Agency paper with a +/-5 year maturity will rise, destroying shareholder's equity, I don't think the Fed can control those rates. The Fed can really only control very short maturity rates. And the Fed does not control yields on Agency bonds directly, only the short term rate that the Fed itself charges banks. Would you agree?
Regarding the many repo lines in place, I don't really know why the major banks will lend to NLY and other mREITs at a 0.5% interest rate. Suffice to say there is no guarantee they will continue to do so. I would not do so because I don't think I would be getting paid for the risk. Of course, if I could borrow from the Fed at a 0% interest rate, I might change my view but I can't.
I am not an NLY short. I have never had any position, long or short, in any REIT. I disagree that there is a need to be either long or short in one's view of public company share prices. I choose instead to be long on a portfolio of individual loans secured by real estate, where I have personally inspected each underlying property and assessed that my loan is well-secured.
That being said, your approach seems logical and if I do ever initiate a program of investing in REITs, I will refer back to your comments as a good starting point for evaluating some of the key issues in determining fair value for a mortgage REIT.
Billie, Ggrins and Katgod, thanks for your comments.
I will have more input on my view of the risk-reward mix with Chimera given the current share price after doing more homework on the the non-Agency bonds held by the company. Whatever I can find out, I will put in my next article.
To really have an opinion in this case, I would want to spend a lot more time evaluating the business, hearing and meeting management, etc. I understand that traders frequently form opinions based on very limited information but I am not wired that way, so I will just write up what I am comfortable saying, based on the amount of work I have done. This will probably fall short of a formal buy or sell recommendation, in the case of Chimera. There is a huge dividend yield but also clearly some risk of further capital loss.
I am told there has been a lot of insider buying recently, but I have not confirmed this myself. The insiders clearly know a lot more about the company's prospects than I do, so if there is a lot of insider buying, I doubt the company's stock is about to drop dramatically.
I looked up the "Barbell Strategy" and below is what the company says about it. If rates on the company's longer-dated holdings started to rise, and the company anticipated them rising quite a bit, maybe the company could sell those securities and replace them with shorter-dated securities and floating rate securities that perform better in a rising interest rate environment. That would reduce the dividend dramatically, but a smaller dividend is much better than a capital loss. I suppose a holder of this stock would have to be comfortable that management will recognize when the music is about to stop and would be quicker than average to grab a chair, so that "somebody else" takes the hit on the longer-dated fixed rate securities, rather than Annaly taking the hit.
FROM ANNALY'S WEBSITE:
We structure our portfolio using the “Annaly MBS Barbell StrategySM®.” This strategy utilizes a combination of adjustable-, floating-, and fixed-rate mortgage-backed securities so that it can perform throughout a wide range of interest rate environments. At one end of the barbell are adjustable-rate and floating-rate securities or swaps. These securities tend to outperform when interest rates rise because their yields will increase as interest rates rise due to the adjustable nature of their coupons. On the other end of the barbell are fixed-rate securities. These securities generally experience capital gains when interest rates are falling, which help to offset the lower yields and faster prepayments associated with falling interest rates.
Harry, I don't think your question is a dumb question. But I don't really know the answer, either. I am hoping somebody can shed some light on your specific question.
As a general observation, I don't think there is any playbook set in stone right now. Somebody in our society (probably everybody) is going to have to take a hit, either through higher taxes, or lower pension benefits, or a decrease in public services, or fewer subsidies for home ownership, or a loss of some principal here or there. Nobody is going to rescue us...we have to rescue ourselves.
Tondog and kwm3, thanks for both of your comments. I have gotten the sense from reading SA articles that NLY is well run, for a business of its kind. I only analyzed this company (rather than one of the others, more highly leveraged names) because it appeared to be the largest Agency mREIT. I undertand others may have more risk and/or less experienced management.
Regarding the dividends paid out by NLY, it is interesting that they have paid out more than $18 of dividends in the past 10 years. Still, that doesn't protect someone who buys the stock today from a loss of principal, in case of turbulence in the coming months and years.
As far as it being hard to get rich while being cautious, I am just trying to string together a series of successful investments, without taking losses. I don't have the stomach for huge ups and downs!
Ayesha, I do not have any reason to question Annaly's books. That is not where I am suggesting the risk lies.
In my view, this is just a leverage machine, not too different from many of the investment banks prior to the financial meltdown. Fortunately, Annaly has a very simple business model, whereas the Wall Street firms are very complex.
There is probably some price at which it would be attractive, especially with the current dividend. But that price is far below the current value, from my perspective, given the risk and unknowns.
I prefer to invest in loans secured by real estate, where I can go see the real estate myself and decide how much the collateral is worth. And I don't use much leverage at all. That keeps things simple. The yield may not be quite a juicy as Annaly's current dividend, but the risk of capital loss is minimal, if everything is done properly.
Chartreux, I have not been following this company for long at all. I am hoping that some members of the Seeking Alpha community who have followed the stock for longer than I have will provide some insight.
One of my main concerns is that interest rates are so low now, there is only one direction they can go...up. (Admittedly, we could enter a Japan-like lost decade in which case rates could be low for many years, but let's hope the U.S. is different from Japan in this respect).
So, one guess as to why the stock is a little lower now is that investors are pricing in the risk of a destruction of shareholders' equity via a drop in the value of Annaly's assets (if mid-term interest rates rise).
Brad, your question deserves a thoughtful response and I haven't done the homework to be able to answer that question in any detail. I did write an article recently analyzing one REIT, Equity Residential. In short, I think most REITs use much less leverage than Annaly does, making them inherently less risky. However, my sense is that REITs are trading at rich valuations as well, relative to the value of the underlying real estate. My article "2 Roads Diverge in Commercial Real Estate" outlines how commercial real estate has bifurcated into two separate markets. REITs own the "high quality" product but for that privilege, they are paying a huge premium--too high of a premium, in my view.
YieldSeeker, your question is the right one to ask, in my view. As the second article in this series will outline, I don't think they will do well if rates rise. The value of Annaly's assets, which have a maturity of several years, will drop if rates rise. But the amount that NLY owes will stay the same. So a rise in rates will have an immediate impact on shareholders' equity.
The effect on Annaly's earnings is harder to predict. That depends on which rate rises more, the yield on 5 year Agency bonds or Annaly's borrowing costs.
Roni25, as I mention in the article, I am not a professional stock market analyst and I don't have any price target. I am just applying the same approach that we use when evaluating private income-oriented investments (income producing real estate, and loans secured by real estate) to NLY.
My only thought on NLY, as I will detail in the next article, is that the stock is priced to perfection. It is easier for me to see the stock lower than it is today and hard to see why it could go much higher.
I agree with Bruce909 who made a comment below. In addition to the known unknowns, there are "unknown unknowns" with this company, and the 6 to 1 debt to equity ratio means any unwelcome shocks will have a magnified effect on shareholder equity.
Qualquan, I personally prefer to do the math a little differently. I would not look at or incorporate any operating expense when calculating the spread between the yield on investments and the interest rate at which the company can borrow.
The technique I am using a is "quick and dirty" way to figure out cash-on-cash returns that we use when evaluating a real estate investment. We look at the unleveraged yield available from the property (the "cap rate") and then we look at the mortgage constant on the loan that is available to provide a portion of the financing for the acquisition. If we take the difference between the two, and multiply it by the ratio of debt to equity, we get a good estimate of the cash-on-cash return. Namely, the cash flow after debt service as compared to the down payment required to purchase the property.
This same approach can be applied to a mortgage REIT, though I would not venture to say that it is the established way to look at company finances.
I think where your calculation gets into trouble is that it deducts an expenses when calculating the spread between the two numbers, and then multiplies that spread by the ratio of debt to equity. To avoid trouble, just leave all the G&A expenses out when calculating the "cash on cash return". Then you can estimate how much cash flow is being diverted to operating expenses--or set aside as retained earnings--by looking at the difference between the theoretical cash on cash return, and the actual dividend yield.
You are correct, this is a typo. I will request to get it fixed to say $400 million rather than $400 billion. I intended to annualize the quarterly interest expense by multiplying the $100 million number by four.
Dennis, I agree with your observation that to earn returns in the teens in real estate requires time and effort.
Wouldn't you agree that to earn returns in the teens in any investment, without taking on significant risk, requires time and effort?
Also, it is possible to invest passively in these types of programs to earn attractive risk adjusted returns (as the long as the sponsor is trustworthy and can execute--two big assumptions that require very careful due diligence).
You mention that "people can get better returns on all that cash" without the headaches and risks of being a landlord. I would be interested to know where you think there are better risk-adjusted returns available in any market today. Having spent 9 years 100% focused on being a professional real estate investor, sponsor and fund manager, I am not aware of anyplace in the real estate markets providing better risk-adjusted returns currently...as long as you or someone you trust is willing to do the work.
Steve, you make a good point regarding how credit tenant income is viewed very differently from non-credit tenant income.
In our approach, we look at the underlying real estate and its ability to generate income. Even a top credit tenant can go bankrupt (remember, Lehman Brothers was considered a great tenant until a short time before they blew up).
One interesting phenomenon I have seen is that some investors buy single tenant buildings (such as a restaurant on a pad in a shopping center) at very high prices per square foot, because the credit of the tenant is good and they like the income. I have seen Starbucks shops sell for more than $400 or $500 per square foot.
In my view, they neglect that a large portion of the income stream they are receiving is really attributable to elaborate tenant improvements that have been capitalized into the lease. These improvements are customized to one tenant, and will have much less value to any other tenant. In other words, when that lease comes to an end (assuming the tenant stays in business for the entire term of the lease), the new tenant will pay a much lower rent.
With these tenant-credit-reliant investments, the mantra is "enjoy the income while it lasts" because once it is gone, you will discover that you paid too much for the real estate, relative to its underlying value.
I have read all the comments so far with interest. Most seem bearish on the housing market.
I agree that in some places (say, Detroit), replacement cost is irrelevant. In Phoenix, which I chose simply because I was there recently and I had the opportunity to collect some ground level data, I believe population will continue to increase over time, even with the new anti-immigration stance of the state. There is still a trend of older people moving there from colder climates, as well as cost-conscious businesses from places like California locating facilities there to take advantage of the lower cost of living (e.g. Intel's "Fab 42").
In Phoenix, in my view, home building will start again sometime in the next 5-7 years and at that point, replacement cost will become relevant. My only point is that values are much more likely to rise than to fall in the coming years in places like Phoenix (though in the short term they could fall further).
Soon I will be submitting a second article analyzing the economics of creating portfolios of rental homes in selected Southwestern U.S. markets. This is a difficult strategy to execute but some groups are making money doing it and enjoying strong current cash flow relative to the cash flow from, say, buying apartment buildings.
Algo41, good question. The $146 million we started with is operating income. That is before interest income and interest expense are accounted for. That's why we did not need to make any adjustments.
To put it another way, the $146 million number is just the actual quarterly revenue, less maintenance expense, property taxes, payroll and a few other line items which are expenses associated with operating the properties and running the company (general and administrative expenses). I hope this clarifies how the analysis was done.
There is a very solid observation at the core of David's article. Single family home values in some areas have fallen so far that homes can generate attractive income. In fact, while homes normally deliver a lower rental yield than commercial real estate, today the relationship has flipped. Homes generate higher yield than, say apartments or shopping centers, in many cases.
Still, being a landlord for a portfolio of single family homes is unappealing to many. For more passive investors, a great way to play this niche is to be a lender to experienced rehab specialists who buy homes from banks. To learn more, please check out a variety of educational material on the subject at arixacapital.com/blog.
Disclosure #1: I do not sell trust deed investments.
Disclosure #2: I do manage a portfolio of trust deed investments (real estate loans).
I would like to see a more fundamental analysis of these mortgage REITs. The "price-to-book-value" column is interesting but the the question is, what is that actual value of the underlying real estate? What is the actual cash flow before debt service of the underlying real estate? A yield of 12-19% is certainly appealing, but not if there is a significant risk of capital loss. The only way to assess the risk of a capital loss is to look at the real estate underlying the mortgage pool, and where in the capital stack the mortgages fall.
We don't do this on mortgage REITs, but we do invest in individual mortgages. To ensure a margin of safety, we analyze an investment in a loan as if we were buying the property. The key question to ask is, "Would we be comfortable owning the underlying real estate at the applicable cost basis, assuming the borrower defaulted on the loan."
I understand that SeekingAlpha is focused on investing in publicly traded securities. When discussing preferred stock in a REIT, it seems to me that there is another way to look at it: from the bottom up.
Preferred stock in a hotel REIT is similar to a mezzanine investment in a hotel. It is senior to the equity but junior to the debt. The key question is, what is the income of the hotel, and what is the amount of the debt and mezzanine financing, and how does that compare to the value of the property.
The reason REIT preferred stocks traded down so much during the financial crisis, among others, is that there was no visibility on whether REITs could refinance their senior debt when it came due. This meant that conceivably the REITs would fall into the hands of the debt holders, wiping out the equity as well as possibly some or all of the preferred.
For AHT's REIT shares, the key is to analyze the cash flow of the portfolio hotels owned by AHT. My guess is that there is plenty of cash flow to pay the debt service plus the preferred, but looked at this way, 8.45% may not be so attractive after all. For example, we are achieving returns better than that on short term *senior* loans secured by real estate. When we make junior loans (which are similar to preferred equity), we charge an all-in rate in the teens (13%+).
Granted, REIT preferred equity is much more liquid than individual mezzanine investments in real properties. However, REITs are richly valued today. They generally sell for a premium to the value of the underlying real estate in their portfolio (reference: Green Street Advisors research). As just one example of how richly valued REITs can be, check out Equity Residential (Ticker: EQR). It is yielding only about 2.2%. There is lots of froth in that valuation, in my opinion. Most likely their preferred would drop in value at least a little if the price of the stock came down, which entirely possible.