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

Annaly's investment in commercial real estate give the company a true competitive advantage over competitor American Capital Agency, here's how.

Jun 5, 2014 at 10:22AM

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.

Is Annaly the top dividend stock for the next decade?
The smartest investors know that dividend stocks simply crush their non-dividend paying counterparts over the long term. That's beyond dispute. They also know that a well-constructed dividend portfolio creates wealth steadily, while still allowing you to sleep like a baby. Knowing how valuable such a portfolio might be, our top analysts put together a report on a group of high-yielding stocks that should be in any income investor's portfolio. To see our free report on these stocks, just click here now.

Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

1 Key Step to Get Rich

Our mission at The Motley Fool is to help the world invest better. Whether that’s helping people overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we can help.

Feb 1, 2016 at 4:54PM

To be perfectly clear, this is not a get-rich action that my Foolish colleagues and I came up with. But we wouldn't argue with the approach.

A 2015 Business Insider article titled, "11 websites to bookmark if you want to get rich" rated The Motley Fool as the #1 place online to get smarter about investing.

"The Motley Fool aims to build a strong investment community, which it does by providing a variety of resources: the website, books, a newspaper column, a radio [show], and [newsletters]," wrote (the clearly insightful and talented) money reporter Kathleen Elkins. "This site has something for every type of investor, from basic lessons for beginners to investing commentary on mutual funds, stock sectors, and value for the more advanced."

Our mission at The Motley Fool is to help the world invest better, so it's nice to receive that kind of recognition. It lets us know we're doing our job.

Whether that's helping the entirely uninitiated overcome their fear of stocks all the way to offering clear and successful guidance on complicated-sounding options trades, we want to provide our readers with a boost to the next step on their journey to financial independence.

Articles and beyond

As Business Insider wrote, there are a number of resources available from the Fool for investors of all levels and styles.

In addition to the dozens of free articles we publish every day on our website, I want to highlight two must-see spots in your tour of fool.com.

For the beginning investor

Investing can seem like a Big Deal to those who have yet to buy their first stock. Many investment professionals try to infuse the conversation with jargon in order to deter individual investors from tackling it on their own (and to justify their often sky-high fees).

But the individual investor can beat the market. The real secret to investing is that it doesn't take tons of money, endless hours, or super-secret formulas that only experts possess.

That's why we created a best-selling guide that walks investors-to-be through everything they need to know to get started. And because we're so dedicated to our mission, we've made that available for free.

If you're just starting out (or want to help out someone who is), go to www.fool.com/beginners, drop in your email address, and you'll be able to instantly access the quick-read guide ... for free.

For the listener

Whether it's on the stationary exercise bike or during my daily commute, I spend a lot of time going nowhere. But I've found a way to make that time benefit me.

The Motley Fool offers five podcasts that I refer to as "binge-worthy financial information."

Motley Fool Money features a team of our analysts discussing the week's top business and investing stories, interviews, and an inside look at the stocks on our radar. It's also featured on several dozen radio stations across the country.

The hosts of Motley Fool Answers challenge the conventional wisdom on life's biggest financial issues to reveal what you really need to know to make smart money moves.

David Gardner, co-founder of The Motley Fool, is among the most respected and trusted sources on investing. And he's the host of Rule Breaker Investing, in which he shares his insights into today's most innovative and disruptive companies ... and how to profit from them.

Market Foolery is our daily look at stocks in the news, as well as the top business and investing stories.

And Industry Focus offers a deeper dive into a specific industry and the stories making headlines. Healthcare, technology, energy, consumer goods, and other industries take turns in the spotlight.

They're all informative, entertaining, and eminently listenable ... and I don't say that simply because the hosts all sit within a Nerf-gun shot of my desk. Rule Breaker Investing and Answers contain timeless advice, so you might want to go back to the beginning with those. The other three take their cues from the market, so you'll want to listen to the most recent first. All are available at www.fool.com/podcasts.

But wait, there's more

The book and the podcasts – both free ... both awesome – also come with an ongoing benefit. If you download the book, or if you enter your email address in the magical box at the podcasts page, you'll get ongoing market coverage sent straight to your inbox.

Investor Insights is valuable and enjoyable coverage of everything from macroeconomic events to investing strategies to our analyst's travels around the world to find the next big thing. Also free.

Get the book. Listen to a podcast. Sign up for Investor Insights. I'm not saying that any of those things will make you rich ... but Business Insider seems to think so.


Compare Brokers