Ouch, a terrible selloff Tuesday (May 28, 2013) continued into the morning session yesterday (May 29, 2013) which knocked the mortgage real estate investment trusts (mREITs) down sharply on continued fears that the Federal Reserve will cease its asset purchases and interest rates will rise. By the end of the trading session yesterday, mREIT stocks had recovered most of their morning losses.
Why so volatile? While the Fed has not confirmed or denied any actions yet, interest rates have been on the rise in the last few weeks, which can pressure the mREITS as I will discuss below. In fact, mortgage rates have now spiked to their highest level in a year, which has further pressured the mREITs. May has been one of the most awful and painful months in history for investors in mREITs as the entire sector has seen a selloff after poor earnings from both American Capital Agency (AGNC) and Annaly Capital (NLY). In light of the recent action, I was compelled to write an article about AGNC questioning whether it was time to abandon ship on the stock. Interestingly, the article garnered more inquiries regarding the future of NLY, the largest public REIT financier of residential mortgages on the globe. Further some feedback even suggested that the ship was completely sinking on the entire mREIT sector. Others contend that it's all "aboard time" as the fears were overplayed. Regardless of the clever maritime metaphors, in response to reader demand and feedback on both the buy and sell sides, I felt compelled to share my thoughts in more detail on AGNC's main competitor, NLY.
The Selling Began With Poor Earnings
The NLY earnings report was definitely weaker than expected but the company remained profitable. NLY reported GAAP net income for the quarter of $870.3 million or $0.90 per average common share as compared to GAAP net income of $901.8 million or $0.92 per average common share for the comparable 2012 quarter. Its GAAP net income was reported as $700.5 million or $0.70 per share. The annualized yield on average interest-earning assets was 2.37% and the annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps, was 1.46%, which resulted in an average interest rate spread of 0.91%. The market didn't appreciate that report, and the stock was hit shortly after reporting.
Book Value Dropped
Given the poor climate in the first quarter, the reported book value as of March 31, 2013, for NLY was $15.19, down from $15.85 as of December 31, 2012, which as a loss of 4.1%. At the end of the third quarter of 2012, NLY had a book value of $16.60. When the company reported its earnings for the second quarter of 2012, the book value was $16.23 per share. Seeing movement in book value quarter to quarter is quite normal, however this marks two consecutive quarters of declines. After the disappointing first quarter, book value is at its lowest in nearly a year. Book value is a key driver to the stock price of any mREIT. It represents the net asset value of the stock. I always recommend buying when there is a discount to book value, and never at a premium. The latter is just bad business and only justifiable if there is solid evidence book value will rise at the next earnings report. For more on the significance of book value, I highly recommend consulting this recent piece.
As Headlines Drive Price Action, Is NLY A Buy or Sinking Ship?
Most readers understand how NLY and its competitors profit. On the most basic level, they borrow money at low rates, purchase mortgage assets and in turn lend at higher long-term rates to customers. Here's the problem the mREIT stocks are facing. Companies that purchase bundles of residential mortgage-backed securities issued and guaranteed by any of the federal agencies in the United States will be under unremitting pressure from headlines and big money institutions because Wall Street continues to question when the Federal Reserve will cease its asset purchasing. Note that the Fed has not committed to any changes whatsoever. It is all speculation at this point. When the Fed announced it would purchase assets, mREITs got hit. When there is speculation the Fed is exiting, mREITs get hit. When the Fed ultimately exits, they will probably be hit again.
The pressure has been rising for the last few months of this unending rally in the markets as the U.S. economy has rebounded. What is important to consider is that while many of the domestic numbers are improving, the global economy is limping along. China is slowing and much of Europe is in recession. Thus, the U.S. is still at high risk. So what's the issue with mREITS? Well the most important thing to realize is that the market is baking in higher mortgage rates and an assumption that the Fed will exit very prematurely. It is true that it is not a question of if the Fed backs off (as purchasing cannot go on forever) but when it will. What investors in NLY and its competitors such as AGNC need to understand now is that the mREIT stocks have sold off before any of this has occurred. The Federal Reserve however will be cautious in ceasing asset purchases because all of its efforts could be in vain if it stops purchasing too soon and sends the economy back into recession. Because the global economy is weak, the U.S. cannot thrive on its own; we are too interconnected. Thus, it is quite likely, in my opinion, that the Fed will not exit until its 6.5% unemployment rate target is achieved. I think it would also be premature to exit before we see sustained 2.5-4.0% GDP growth.
Is The Fed Good, Bad or Ugly for NLY?
All of this Fed action has been both good and bad for NLY. First, the government-backed quantitative easing policies have made it cheaper for mREITs to borrow funds to invest in residential mortgage-backed securities. Second, the low borrowing rates have helped the housing market rebound in general, which is also good for business. The issue that has plagued mREITs is that while the borrowing rates are low, at the same time the rates at which NLY can sell longer-term debt are also quite low, which has resulted in mREITs earning less. This is known as a narrowing of the interest rate spread, which is vital to profitability. In turn this has resulted in the aforementioned book value depreciation and cuts to the dividends paid to shareholders. The ideal situation is a booming real estate market with a low short-term borrowing rate and a high long-term borrowing rate. Right now, both the short and long-term rates are quite low, even with the recent rise in the thirty-year rates. We have seen a gradual flattening of the yield curve. If the Fed exits too soon, first investors may continue to dump the stock in consideration of the second issue, which is that short-term interest rates may rise too quickly costing the companies more to borrow and hurting the profit margin. In the long run we will see if the Fed's actions have helped or hurt NLY, although NLY has been relatively strong in the last four years of Fed action. However, anytime the Fed says anything regarding its purchases, the mREITs seem to bleed red from selling. The recently released FOMC minutes of the April 30th-May 1st meeting on May 22, 2013, showed that several FOMC participants are pushing to taper asset purchases as early as June, when the FOMC is scheduled to have its next meeting. Sparking fear into the broader market, participants also hinted that a stock market bubble could be in the works, while others warned of the risks of deflation and pushed for more QE. Clearly the FOMC is divided, however, the voices calling for ending the asset purchases are on the rise and this has resulted in ugly action in NLY.
NLY is Moving Toward Becoming a Hybrid REIT
I have encouraged REIT investors to consider diversifying into hybrid REITs, companies that have exposure to both residential mortgage-backed securities and commercial-backed mortgage securities. NLY has always been heavily invested in residential mortgage-backed securities. However, given the market climate, management has recognized that the commercial real estate market has yet to pick up steam compared to the residential market. The one move NLY has made that makes me believe in owning this stock for the long-term, despite all of the headline risk and short-term volatility, is that the company has recently completed the purchase of CreXus (CXS). CreXus acquires, manages and finances, directly or through its subsidiaries, commercial mortgage loans and other commercial real estate debt, commercial real property, commercial mortgage-backed securities and other commercial and residential real estate-related assets. Also, NLY will rename the company to Annaly Commercial Real Estate Group following the closing of the merger. This purchase will allow NLY to diversify its investment portfolio and when commercial real estate mortgage picks up, it will help future earnings growth. Chief Executive and Chair of the Board Wellington Denahan said of the acquisition during the last conference call:
"The CreXus's acquisition is accretive to the Annaly dividend and represents a meaningful step in the evolution of Annaly's capital allocation strategy, one that will enable us to take advantage of a broader spectrum of investments. Since the announcement of this acquisition in November, we have continued to build out our commercial expertise and we remain confident that CreXus' capabilities and growth may be significantly enhanced when coupled with Annaly's broader capital base."
The commercial real estate market has lagged the residential real estate market. With evidence that the US economy is on the rebound, it is likely the commercial mortgage market will be a significant source of revenue moving forward.
I'm Back in The Stock And I'm Adding Now
I recently sold a significant portion of my position in AGNC after earnings. I utilized the proceeds to establish a very small position in Western Mortgage (WMC) and picked-up a small portion of AGNC stock 5 points below where I sold it because of where it is trading relative to its quarter end book value. Given comments from WMC, AGNC and NLY management regarding the anomaly of the first quarter 2013 on the conference call, I believed current book value may have been higher than where it was quoted at the end of March. With the recent action however, it remains to be seen if this is correct, especially given the rise in interest rates. Last Friday (May 24, 2013) I also picked up a tiny position in NLY. Yesterday, when NLY hit $13.25 I doubled that position because I think its diversification into the commercial space was wise and opens it up to a new source of revenue, especially once the commercial market picks up.
Given the uncertainty in the mREIT space I have reduced my overall mREIT portfolio allocation from 7% down to 4% as caution is warranted. I will look to add if the stock hits $12.00. While the waters will be rough for a while, and there may be more pain ahead, for the long-term I think investors in NLY can add to their positions especially if they are reinvesting their dividends over the long haul. However, I would caution investors not to allocate a large portion of their portfolio to this, or any other sector, as diversification is the best weapon against a volatile market.
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