Annaly: A Smart Buy For 2012

| About: Annaly Capital (NLY)

When looking at REITs, I have to look at commercial and residential properties, and real estate ownership versus mortgage holding. There are definitely signs and arguments that the residential housing market will eventually rise, but there are several factors that need to be worked through first. I believe that a mortgage REIT such as Annaly Capital Management (NLY) has some reasons to be optimistic, as do owners of Annaly Capital's stock - once these factors are taken into consideration.

I have worked in the commercial and residential development industry, with a focus on commercial properties. When handling marketing and market differentiation, I learned about the differences of the construction part in both markets in both a good economy and a much worse one. I've seen both unsold new homes, and industrial parks where practically every building is partially or wholly for sale or lease. Annaly Capital is, in a word, huge, the largest REIT in U.S. residential mortgages. Its earnings multiple (price to earnings ratio) is also relatively huge, at 42.89 as of this writing, giving one measure of higher earnings growth potential, especially when compared with other companies in same industry. Annaly also owns several subsidiaries and indirectly manages two other REITs, is in the business of understanding all of these financial transaction types, and uses their multi-enterprise empire to manage risk - with the performance stats to back up their success.

One of the REITs owned by Annaly is Chimera (CIM), and it invests in residential mortgage-backed securities (NASDAQ:RMBS), residential mortgage loans, real estate-related securities and other asset classes, with an earnings multiple of 5.02. Basically, Chimera is "banking" on government-backed mortgages, like Annaly. The situation here is that Chimera represents only a small portion of Annaly's total family of businesses/subsidiaries, but its focus is more on residential housing mortgages.

People always need a place to live, and rents still are going up - part of the problem that the more financially strapped everyone becomes, the more everyone tries to charge the next guy to make up for the shortfall. Rather than a vicious circle, it's more of a line, heading downward with the individual consumer at the bottom, unable to pass on their problems to anyone else except by not buying non-necessities. And yes, this is a great part of the overall economic problem. We all need a place to live, and if the monthly expense to own isn't much greater than renting, the desire to own gets higher. With the lure of low interest rates and tax write-offs, anyone who can be approved for a mortgage and come up with the down payment has a reason to buy, even if it's not in the home they want to live in permanently.

Another REIT to look at is Invesco Mortgage Capital (IVR), which focuses on both commercial and residential mortgage-backed securities and loans, with a price to earnings ratio of 5.38. For Invesco, only part of its portfolio is comprised of residential mortages, and includes those both guaranteed and not guaranteed by a U.S. Government agency.
This means its risk is spread between these groups, and improvements in any part (commercial or residential, government-backed or non-government-backed) may benefit the stock.

Looking at Acadia Realty Trust (AKR), it is a self-managed equity REIT that focuses on the ownership and management of the properties themselves, specifically mixed-use and retail properties such as shopping centers. This means Acadia Realty is putting a lot of hope into retail success, which is an entirely different animal than residential housing. Would I pay my monthly rent/mortgage first, or go shopping for an HDTV, if my funds are limited (which of course they are)? Its focus on this specific area does not make it a strong contender as compared to the residential housing mortgage REITs. However, its earnings multiple of 46.47 is very large, bigger even than Annaly's. This doesn't mean that I'm predicting less success for Acadia Realty overall, just in the context of the residential housing market.

Finally, I reviewed Hatteras Financial (HTS), an externally-managed mortgage REIT with a price to earnings multiple of 7.10 and a specific investment preference: adjustable-rate and hybrid adjustable-rate single-family residential mortgage pass-through securities, issued or backed by one of the government agencies (Fannie Mae, Freddie Mac or Ginnie Mae). Like Annaly, Hatteras is focusing on residential mortgage, but especially those pass-through securities. As this represents interest from a pool of mortgages, Hatteras is really representing bonds. This structure means all principal and interest payments from this pool go to investors monthly. For the most part this is very steady income, based on consistent, fixed monthly payments. Cash flow can still vary, however, as some mortgagors pre-pay mortgages when possible in order to take advantage of lower interest rates to refinance. Our current low interest rates make this unpleasant side effect to investors more likely, even though there is little overall credit risk and government guarantees in place.

I was taught when I house-shopped for the first time that, except for the very wealthy, it's sort of like buying art. There are many potential reasons to invest in a piece of art (a sick and dying artist whose fame post-mortem will make the price skyrocket seems to be a popular one), but really I will be holding on to this artwork perhaps for years, even passing to generations. It would make the most sense if I actually liked the work, really enjoyed looking at it and being happy to own it. Those who bring their treasures to art appraisal shows are often delighted to hear their decades-held piece of art is worth a fortune, but most of the owners use this to get insurance to protect their home and have no intentions of selling it. Those house-flipping shows have also made the acquisition, renovation and selling of houses with no intention of living in them seem like a fast way to make money, especially when interest rates and housing prices are this low. But as with the art, if I don't find the location or style of house anything I personally want to live in or even like, and I'm viewing this solely as an investment, I find myself still needing to take care of my primary need - shelter.

There is the "I feel like a fool" effect of those who bought their house when prices were artificially high, and now refuse to sell in this market, even if they can afford to, because they are convinced that their home is worth more because they paid more to get it. Alas, housing prices, like art, are not fixed, known entities - there are what the market will bear, and once 300 million people know that houses bought five years ago are worth, for example, 20-30% less, no one is going to buy the overpriced house unless they really, really love it. Although houses are still going into default, these are the houses that had already been in the economy before the recession, not so much newer purchases since mortgage restrictions became tougher. So, although the houses still in trouble may not find a resolution soon, going forward, there is more security in the mortgage interest paid in a steady manner, keeping mortgage REITs alive, and eventually increasing their earnings as interest rates start to rise during the recovery. Annaly's board of directors knows this, and so do those, like me, who think Annaly is a smart buy right now.

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

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