Here's Why mREIT Stocks Are Tanking

Despite a relatively quiet day in the markets, shares of virtually every mortgage real estate investment trust are sharply lower today. To name only the best known, industry giant Annaly Capital Management (NYSE: NLY  ) is down by 4.2%, American Capital Agency (Nasdaq: AGNC  ) by 3.8%, and ARMOUR Residential (NYSE: ARR  ) by 4.4%. What gives?

A tough year for mREITs
Let's begin with the fact that it's been a tough year for mREITs in general. As the Federal Reserve has sought to drive down long-term interest rates via quantitative easing, the interest rate spread that these funds rely on to make money has contracted. Since the third quarter of last year, Annaly's went from 2.08% down to 1.02% today, and American Capital's from 2.14% down to 1.42%.

It follows that the compression of interest rates has obligated these companies to decrease their lucrative dividends payouts. Over the last 12 months, Annaly's quarterly payout went from $0.60 a share down to $0.50, American Capital's from $1.40 a share to $1.25, and Chimera Investment's (NYSE: CIM  ) from $0.13 a share to $0.09. And this, in turn, has put downward pressure on many of these companies' stock prices.

Is Annaly's acquisition of Crexus a canary in the coal mine?
But all of these things have been known for some time now and are accordingly not the impetus for the industry's terrible performance today. That unenviable handle goes instead to an announcement yesterday that Annaly has submitted a bid to purchase Crexus Investment Corp. (NYSE: CXS  ) , a REIT that specializes in commercial real estate.

On the surface, the deal doesn't look like anything to write home about, as Annaly already owns 12.5% of Crexus and controls the company via its wholly owned subsidiary FIDAC. In addition, as I discussed earlier today, with less than $1 billion in assets, Crexus' holdings will be but a drop in the bucket compared to Annaly's $141 billion balance sheet.

It nevertheless matters because of what it says about the current travails of the mREIT industry, and particularly those mREITs like Annaly that focus on so-called agency mortgage-backed securities that are insured by government sponsored entities such as Fannie Mae and Freddie Mac. Over the past year, the yields on these securities have declined significantly as competition for them has heightened in the wake of Operation Twist and QE3 -- through which the Federal Reserve is purchasing $40 billion to $65 billion a month, or a lion's share, of new agency-backed MBS issues.

Annaly's proposed purchase of Crexus, in turn, is being seen as an acknowledgement that the agency MBS model is unable to function in the current environment -- a canary in the coal mine, if you will. And it's for this reason FBR Capital Markets reduced its price target on Annaly this morning to $13.50 from $16 and maintain its underperform rating on the stock -- the company currently trades for $14.25 a share.

It's worth noting, moreover, that FBR's move comes on the back of similar downgrades at other investment banks. In the middle of last week, no less than three analysts preemptively followed suit. Barclays downgraded Annaly to equal weight, Nomura cut its price target on the company to $15 from $17.25 previously, and analysts at Jefferies Group maintained their hold rating. All of these moves followed Annaly's disappointing third-quarter results, which missed the consensus estimate on the bottom line.

What's an income investor to do?
While many analysts and commentators have been anticipating a downward move in mREIT stock prices, that is no consolation to investors currently holding shares in the likes of Annaly, American Capital, or Chimera -- though Chimera has its own set of more serious problems. To those shareholders, I say it's my opinion that the market is overreacting to general trends that we've seen coming for some time now.

Here at The Motley Fool, we implore investors to avoid the allure of trading stocks on the heels of information like this. What investors should do instead is educate themselves further about the companies they own. It's for this reason that our in-house specialists on Annaly Capital Management have created a new, in-depth report on the mREIT giant. The report identifies both the opportunities and a number of shocking risks that the company faces. To download a copy of this report instantly, simply click here now.


Read/Post Comments (5) | Recommend This Article (20)

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  • Report this Comment On November 13, 2012, at 4:36 PM, roydale wrote:

    How can it make sense to sell NLY at $14.46, today's closing price -- regardless of compression in NIM's?

    --This represents a 13% discount to the book value at 9/30/12 of $16.60.

    --If NIM has narrowed to 1.02%, this still affords a dividend yield of over 8% at 7 times leverage (7x the spread plus one dollar of equity invested outright) -- in a zero percent interest rate environment.

    --Most baffling of all -- investors historically have been satisfied with dividend income of 8% on these REIT issues in environments where alternative income investments were much more attractive (i.e. NOT zero percent). So why do investors find an 8% dividend income stream so unsatisfying today?

    The situation is even more baffling when looking at some of NLY's competitors that invest in adjustable rate mortgages (ARMs), which the Fed does not appear to be buying.

    Consider the following issues -- and their discounts to book value:

    ANH -- 75% of BV (!)

    CMO -- 83% of BV

    There is a robust bid in the securities market for precisely the issues that they own, at a positive spread, with forward dividend rates likely to exceed 10% -- certainly more than 8%.

    If one were able to buy all of the outstanding shares of ANH and sell the assets at book (all of which are government guaranteed agency assets), the ROI on this transaction would be 33% (100 / 75 = 133%)!!!!

    Am I to believe that it is RISKY to buy ANH at these levels......because my income might ONLY be 8%, on a forward basis, and because I have to pay 75 cents on the dollar for all of the assets?

    NIM's are narrowing as the REIT's are forced to reinvest at less attractive levels. Dividends are coming down.

    Who doesn't understand this? Who is surprised by this? And why must a mortgage REIT deliver 12% -- or even 10% -- to be considered attractive relative to a bank CD with similar duration yielding 1/4 of 1%?

    The analysts are outsmarting themselves here, downgrading the companies because dividends are going down -- and because they feel that the market values them on the income streams, rather than the book values.

    The stocks are down because they are responding by opening up large discounts to book value as they fall in price -- as if there was some arbitrary dividend yield that is necessary to make them legitimately attractive.

    But the fact of the matter is that these issues are now trading at significant discounts to their intrinsic values -- i.e. what a bank investor would happily pay for their entire portfolios if they were put out to bid!

    After NLY buys the rest of CXS, it should buy ANH, CMO and HTS! They won't find any cheaper bonds to buy anywhere else!

  • Report this Comment On November 13, 2012, at 7:15 PM, prisco39 wrote:

    Certainly has been a rough couple of days. ARR did go ex today so that is to be considered. I generally find your info quite on the money. What I don't understand is why you give even the slightest attention to CIM. Been a loser for too long to be noticed. You have it as a 4 star rating. Now, that is really FOOLish!

  • Report this Comment On November 13, 2012, at 7:41 PM, JohnMaxfield37 wrote:

    prisco39,

    I agree. CIM is a total dog. I'm not sure why it has a 4 star rating in our CAPS system.

    John

  • Report this Comment On November 14, 2012, at 11:54 AM, investism wrote:

    I think we have two concerns for the REITS:

    Reduced spreads due to ongoing QE3, which we all know and have anticipated.

    And price risk due to possibility of higher tax rates and political uncertainty.

    I think we are in for a bumpy Q4 and roy has point stick with REITS if you can stomach the volatility...

  • Report this Comment On November 14, 2012, at 2:30 PM, paultaut wrote:

    stick with em and as long as you are satisfied with lower valuations and div reductions in the future, you will be happy.

    I expect those REITs which continue to rely soley on the MBS trade will suffer the most.

    Their current higher yielding assets will continue to suffer as mortgages are refinanced into ......

    Ever lower yielding mortgages courtesy of QE3 for the forseeable future.

    Good luck in AGNC in particular. I don't own any and won't until the dust settles.

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