3 Reasons Commercial Real Estate Gives Annaly Capital Management an Edge Over American Capital Agency

The greatest businesses and the best investments have one thing in common, competitive advantage. Whether it's a strong brand name, a vast network, or cost advantages, every great company needs something to ward off competition. 

As a whole, however, the mREIT sector doesn't have a ton of competitive advantage. Strong management can be an edge, and better relationships with lenders can help secure financing -- but, neither has that "wide moat" feel. 

This is why Annaly Capital Management's (NYSE: NLY  )  position in commercial real estate is critical. Despite its relatively small investment size, the portfolio should work as a hedge to the company's residential mortgage-backed securities, or RMBS, drive greater asset yields, and allow for opportunities unavailable to smaller companies. All these factors give Annaly an edge over American Capital Agency (NASDAQ: AGNC  ) . 

Hedge 
In the first quarter, American Capital Agency used what's called a "natural hedge" establishing a $6.5 billion dollar short position on U.S. Treasuries. This way, if interest rates rose (decreasing the value of the company's bond portfolio) the short position would increase in value, and cover some of its losses. 

Annaly's investment in commercial real estate has a similar effect, but works quite differently. Both Annaly's triple net lease portfolio of physical properties, and its investments in mezzanine loans (low-grade commercial loans), are both cash-flow positions. Meaning, the investments will not lose value to the same extent as RMBS's based on interest rate fluctuations. 

More importantly, while commercial loans do come with the risk of default, unlike U.S. Treasuries, they allow Annaly to create additional cash-flow, rather than cancelling it out.

The yield
As Annaly's CEO Wellington Denahan noted in the company's most recent conference call, "Our commercial investment portfolio yields approximately... 9.18%."  For some perspective, Annaly and American Capital Agency's first quarter yield on RMBS's was less than 3%. 

How Annaly is earning this incredible yield is a little trickier. After acquiring a commercial loan, Annaly securitizes it, and then breaks it into pieces by investment "grade." Higher grades get paid back first in case of borrower default, so they're considered safer and receive lower yields, while lower grades have more risk, but have greater yields. 

According Annaly's head of commercial business, Bob Restrick, Annaly leaves the high grade loans for investors, and holds the mezzanine loans -- which are lower grade. 

Currently, Annaly allocates 12% of its equity toward commercial real estate, though, Denahan has mentioned the company is attempting to go as high as 25%. Giving the portfolio -- and more importantly the yield -- a more meaningful impact on bottom line results. 

Size 
Unlike other sectors, Annaly and American Capital Agency's shear size doesn't carve the same type of competitive advantage as it does for, a Wal-Mart or Google

In the commercial real estate market, however, Annaly has the opportunity to flex its muscles. According to Annaly's CFO Glenn Votek, "[Annaly's] capital position is three times the size of the largest commercial REIT."

Though the company will continue to allocation a majority of its equity toward RMBS's, Votek suggested, "we're unearthing... bigger opportunities, more unique pricing and structures because of that capital base." 

The last word 
No investing criteria is more important than competitive advantage. And up until recently it was hard to tell what Annaly did that American Capital Agency or any other mREIT couldn't do. 

However, for another company to exploit similar opportunities it would need a capital base that exceeds any currently competing commercial REIT, a pipeline to acquire and securitize the mortgages, and a completely new team with experience in the sector -- all pretty sizable hurdles. 

Looking forward, I think commercial real estate is expanding Annaly's competitive advantage, and it's, perhaps, the best reason to favor Annaly over American Capital Agency.

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