The COVID-19 crisis threw the mortgage real estate investment trust (REIT) sector for a loop earlier in the year. The sector was crushed by massive volatility in the stock and bond markets, which caused liquidity to dry up in the mortgage-backed securities markets. Even mortgage REITs that concentrated in mortgages guaranteed by the U.S. government were not immune to a drop in stock price.
Since then, stocks that were once largely reserved for income investors became a favorite of the Robinhood crowd of day-traders for a time, creating some volatility in the sector. As of now, it appears that the financial markets aspect of the COVID-19 crisis seems to be over.
Does that make Annaly Capital Management (NYSE: NLY) a buy?
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Mortgage REITs are a different animal
It is important for investors to understand the difference between mortgage REITs and the more typical REIT business model. The typical REIT, which invests in office, retail, or infrastructure, will borrow money to buy real estate assets and then charge rent on those assets to leasees. While there are always financial engineering aspects to what REITs do, for the most part it is an easy-to-understand business model. Mortgage REITs don't own physical real estate assets nor do they charge rent. Mortgage REITs invest in debt secured by real estate and earn interest on those investments.
This business model has advantages and disadvantages. The disadvantage is that mortgage-backed securities can be much more volatile than real assets. A mortgage-backed security can lose 25% of its value overnight if the right set of circumstances comes along, for instance. A building typically won't fluctuate in value that much in that short a time frame. The advantage is that mortgage REITs can be much more nimble than other REITs in terms of their assets. We saw some mortgage REITs completely change their business models over the past six months. A mall REIT simply cannot change its asset allocation structure that quickly.
Annaly cut its balance sheet and dividend
The mortgage REIT sector suffered when liquidity dried up in the structured products markets and their lenders wanted additional capital. Most REITs were able to sell off some of their portfolio, cut their dividends, and continue more or less as before. Some were forced to enter forbearance with their creditors. By late summer, even the hardest-hit mortgage REITs had more or less completed their restructurings. Annaly deleveraged during the spring, cutting its quarterly dividend from $0.25 to $0.22 per share, which was the smallest dividend cut in the sector.
Annaly shrunk its assets by 28% from Dec. 31, 2019, to June 30, 2020. Almost all of the sales were from the government-guaranteed portfolio of mortgage-backed securities. Annaly used the proceeds from the mortgage-backed security sales to pay off repurchase lines of credit. Annaly's debt-to-equity ratio fell from 7.1 as of Dec. 31 to 5.5. As of the end of June, 82% of Annaly's assets are in government-guaranteed mortgage-backed securities, and the rest of the book is primarily in non-guaranteed residential mortgage loans and commercial loans. Non-qualified mortgages (non-QM) account for $2.6 billion and commercial real estate loans account for $2.5 billion. Investors will be keen to get a read on loan performance in the non-QM mortgage sector and the commercial real estate loans when the company reports third-quarter earnings.
Annaly represents a great yield and value
Annaly is trading at a 13% discount-to-book value, higher than AGNC Investment's 7% discount, which is probably the best comparable competitor for Annaly. The difference between Annaly and AGNC is due to the fact that Annaly has higher credit exposure. That said, the more credit-exposed mortgage REITs like MFA Financial trade at discounts around 38%, so discounts can run the gamut.
Annaly's $0.22 per-share quarterly dividend gives the stock a 12% dividend yield, which is one of the highest yields in the sector. While Annaly does have some exposure to the hospitality sector in its commercial real estate portfolio, the office and multi-family residential assets have been performing better.
On the second-quarter earnings call, Annaly announced that it had bought back $175 million in common stock year to date. Overall, most of Annaly's book is government-guaranteed, and the discount-to-book is too high to ignore. A 13% discount-to-book and a 12% dividend yield represent great potential returns, especially for an income investor.
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