3 Reasons to Sell Annaly Capital Management

Mortgage REITs have become increasingly popular investment vehicles over the last few years -- and none more so than industry pioneer Annaly Capital Management (NYSE: NLY  ) . With a yield of 12.3%, Annaly's stock has returned 61% since the end of 2007, beating the broader market by nearly the same amount.

But all good things must come to an end. Since the third quarter of 2011, Annaly has slashed its dividend from $0.60 per share down to $0.50 per share, a decrease of nearly 17%. While this doesn't necessarily mean that the good times are completely over for mortgage REITs like Annaly, it seems safe to say that the returns won't be as good going forward as they've been in the recent past. Here are three reasons why.

1. The Federal Reserve
Roughly three months ago, the Fed announced a third round of quantitative easing, under which the central bank is purchasing $40 billion per month of agency mortgage-backed securities until the labor market improves "substantially."

While many analysts, myself included, speculated at the time that the move would disproportionately impact mREITs, which rely on inexpensive MBSes to make money, we now know the precise contours of said impact. As I've discussed before, and as you can see below, valuations across the industry have declined in the wake of the Fed's move. And given the indefinite duration of QE3, it seems reasonable to assume that this trend will continue.

NLY Price / Book Value Chart

NLY Price / Book Value data by YCharts.

2. The MBS market is getting crowded
In many ways, the mREIT industry is a victim of its own success. Beyond the Fed's increased presence in the market for MBSes -- which has driven MBS prices up and yields down -- multiple new players have entered the market over the last few years, further exacerbating the pressure.

Sources: SEC's EDGAR database. This table was previously cited by me in this article.

To name only the most significant, CYS Investments (NYSE: CYS  ) started operations in 2006, Two Harbors (NYSE: TWO  ) in 2007, and both American Capital Agency (NASDAQ: AGNC  ) and ARMOUR Residential (NYSE: ARR  ) joined the party in 2008. The impact of this is simple as I've noted before: "Because more money is vying for approximately the same supply of agency-backed MBSes, the prices of the latter will invariably remain elevated and their yields concomitantly depressed."

For companies like Annaly, this means a future of more risk and less spectacular returns.

3. Changing risk profile
The final reason that investors should consider selling Annaly is that its risk profile is in the process of fundamentally changing. By investing almost exclusively in agency MBSes for most of its corporate existence, Annaly shielded its shareholders from credit risk, the most incipient of financial threats.

As Annaly's former CEO Michael Farrell put it in a 2007 statement to shareholders:

Since inception, our focus on agency mortgage-backed securities has been a core tenet of [our] philosophy. Because of the actual and implied triple-A rating of these securities, we take virtually no credit risk. Instead, it allows investors in Annaly to judge our performance and potential performance based on our ability to manage interest rate risk. We believe this choice has served our investors well over time and, given the current state of both the credit cycle and the interest rate cycle, leaves us strategically well-positioned for the current environment.

This is now changing. At the beginning of November, Annaly announced its decision to acquire Crexus Investment (UNKNOWN: CXS.DL.DL  ) , a commercially focused REIT operating under the Annaly umbrella of companies. While it appears the move will be immediately accretive to Annaly's profitability, it also exposes Annaly's investors to Crexus' uninsured, albeit significantly smaller, portfolio of assets related to commercial real estate.

To make matters worse, moreover, there's reason to believe that Annaly will continue down this path. At the time of the Crexus announcement, Annaly's CEO Wellington Norris noted (emphasis added):

While we remain committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our shareholders' equity to real estate assets other than Agency mortgage-backed securities.

While this may be a prudent move in the short run, if it proceeded to include, say, the acquisition of Chimera Investment (NYSE: CIM  ) , a highly suspicious and regulatory delinquent non-agency mortgage REIT that similarly operates under the Annaly umbrella, it would be a clear sign that the strategy is being taken too far.

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Read/Post Comments (6) | Recommend This Article (8)

Comments from our Foolish Readers

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  • Report this Comment On December 26, 2012, at 4:14 PM, Doubledip41 wrote:

    Attn: Motley Fool

    It seems that your site has more "advisors" that practice either extreme hype or extreme bashing of a stock in the same manner that occur on the message boards. It seems that they have an interest driving the stock to benifit their positions. I thought that was contrary to MF's intent.

    DD41

  • Report this Comment On December 27, 2012, at 3:24 AM, DavidinNV wrote:

    All things are relative, as the saying goes. My concern is not what NLY's dividend will be in the months ahead, but how the dividend, even after cuts, will compare to other possible investments.

    Suppose I told you of an investment that would yield you about 7 or 8 percent in this low-interest-rate environment. You might be likely to jump at the chance...or maybe not. NLY isn't there yet, but I'm not of a mind to disbelieve that as long as well-managed MREITs are not an overly risky percentage of one portfolio, they continue to have a place.

  • Report this Comment On December 27, 2012, at 8:39 AM, DavidAkre wrote:

    John -

    I agree with the first post about MF becoming a message board for people with positions in the stock. I'll add that many have nothing other than surface knowledge of the subject.

    Where else would you suggest getting a dividend yield similar to NLY (other than some other REIT)?

    How can Crexus not be advantageous from a strategic perspective? Lending in CRE provides much better returns at the moment.

    Relative to their sizes, mortgage REITs own far less than 10% of the MBS market. The limiting factor, one you failed to mention, is the repo market.

    Yes the Fed has shrunk MBS returns and thus margins for mortgage REITs but REITs still deliver solid returns especially when you consider the alternative. This is the new low yield normal.

    BTW I manage a mortgage REIT group on LinkedIn. Maybe you should join...

  • Report this Comment On December 27, 2012, at 10:39 AM, TMFKopp wrote:

    @Doubledip41

    "It seems that they have an interest driving the stock to benifit their positions. I thought that was contrary to MF's intent."

    This is a serious accusation. Do you have any evidence whatsoever to back this up? If you haven't noticed, all writers disclose their stock positions at the end of an article per our company-wide disclosure policy (http://www.fool.com/legal/fool-disclosure-policy.aspx).

    Many of our writers do have strong opinions, but we express those opinions in a very transparent way. If we have a position in a stock we're talking about, you'll know it.

    Matt

  • Report this Comment On December 27, 2012, at 12:06 PM, JohnMaxfield37 wrote:

    DavidAkre,

    1. "Where else would you suggest getting a dividend yield similar to NLY (other than some other REIT)?"

    My point is that these are risky investment vehicles and face a number of headwinds (the Fed, increased competition, etc.). In addition, and this should go without saying, yield isn't the only variable investors should consider.

    2. "How can Crexus not be advantageous from a strategic perspective? Lending in CRE provides much better returns at the moment."

    Like I said in the article: "While it appears the move will be immediately accretive to Annaly's profitability, it also exposes Annaly's investors to Crexus' uninsured, albeit significantly smaller, portfolio of assets related to commercial real estate."

    In other words, like you, I too think the CXS acquisition will be accretive to NLY's bottom line. However, taking on CXS's portfolio represents a dramatic departure to NLY's agency-MBS model, and if NLY goes further down this road (by, say, acquiring CIM), then investors should be wary.

    3. "Relative to their sizes, mortgage REITs own far less than 10% of the MBS market. The limiting factor, one you failed to mention, is the repo market."

    Suffice it to say, I think we can all agree that demand for agency MBSes has gone up over the past five years -- with mREITs being a non-negligible contributing factor.

    John

  • Report this Comment On December 27, 2012, at 3:23 PM, jonkai3 wrote:

    ----------------------------

    1. The Federal Reserve

    Roughly three months ago, the Fed announced a third round of quantitative easing, under which the central bank is purchasing $40 billion per month of agency mortgage-backed securities until the labor market improves "substantially."

    ------------------------------------

    roughly two months ago, 30 year Mortgage rates were trading at roughly 3.4%, today, they are trading at 3.4%... (the prices paid for such rates have also stabilized to roughly the same)

    given that the only effect to worry about from the fed is to make rates less attractive and more expensive... your number 1) has been a none event for about two months and continuing... (actually the rates have been going UP slightly)

    ------------------------------------------------------

    2. The MBS market is getting crowded

    ------------------------------------------------------

    this statement compared to the FED buying about 80% of the market is.... well a none event of epic proportions.... the FED is the crowd.... and the reason one should worry about this is because of more expensive paper and lower interest rates obtained... which as in your number 1) has been shown to have stabilized for two months AND continuing that trend going forward. amazing when you step back and consider the fact that this is happening in the face of all this "crowd" and "buying" by the FED.

    -------------------------------------------

    3. Changing risk profile

    The final reason that investors should consider selling Annaly is that its risk profile

    -------------------------------------------

    yield is a pretty good indicator of how the market views risk, and in that regard, CXS is not much of a change in a risk profile for NLY, only the nature of the risk has changed.

    CXS has delivered a yield that has been trending higher because of the very fact that CMBS has become far more risk adverse than at any time in history...

    mainly because the near 2nd great depression wiped out anything that wasn't viable.

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