3 Things Every Annaly Capital Management Inc. Shareholder Should Hear

Annaly Capital isn't following in its peers' footsteps. See how it differs from another major mREIT, American Capital Agency.

Mar 1, 2014 at 8:00AM


Photo: Flickr/401(K) 2013

Annaly Capital Management (NYSE:NLY) is one of the largest and oldest mortgage REITs, or mREITs, in existence, making it a bellwether for the sector as a whole.

But Annaly Capital is doing things differently than its competitors, reporting better-than-expected earnings in the fourth quarter. Here's what Annaly is doing differently from its competitors:

1. Holding leverage lower than peers
mREITs are all about leverage. The more leverage, the higher the earnings, all else being equal. During this period of volatility in the mortgage markets, Annaly has lowered its leverage to 5 times equity, well under the industry norm of 7-8 times equity.

Company management cites the opportunity that lower leverage created. CEO Wellington Denahan noted that the 2-10 spread (the difference between two- and 10-year U.S. Treasury yields) is now 2.4%, up from 1.6% a year earlier. The 2-10 spread is a good proxy for returns Annaly Capital can earn on agency assets.

By keeping leverage low, Annaly now has additional capital to reinvest in widened mortgage spreads to earn bigger margins between its funding costs and investment yields. Patience is paying off.

2. Buybacks aren't in the cards
Annaly Capital diverges from another major mREIT, American Capital Agency (NASDAQ:AGNC), in turning away from share repurchases. In the recent quarter, American Capital Agency repurchased 7% of its outstanding shares. The two strategies couldn't be more different.

Annaly Capital had some interesting reasons for why it wasn't in the market for its own shares, or shares of its competitors. The reasons were largely to do with liquidity and risk. Repurchasing shares isn't easy to reverse when your stock trades below book value, locking up capital Annaly may later desire to invest elsewhere.

Additionally, investing in other mREITs creates new risks. On the conference call, the company noted that in the past mREITs had been found to own riskier paper. In 1998 and 1999, for example, a major mREIT invested in Russian debt securities at the same time Russia defaulted on its debt. Buying into the abilities of other managers seems unlikely for Annaly Capital going forward. You just don't know where other asset managers will invest the capital. It's all about control.

3. Commercial mortgages may play a bigger role
Annaly's managers revealed that commercial mortgages now make up 14% of the portfolio, and that the position will continue to grow within the 25% of the equity that Annaly allocates to non-agency investments.

Other noteworthy developments are the company's negotiations to work with a "very large holder and originator of real estate that will give [Annaly Capital] exclusive access to certain of its originations." This happens to come at the same time Annaly's commercial team grew to 20 employees, evidence that higher-yielding commercial paper will drive forward earnings.

Commercial mortgages present a unique opportunity to create larger returns, but with added risk. Historically, commercial mortgage mREITs have largely underperformed, so investors will have to have faith in management that maybe, just maybe, this time might be different.

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Jordan Wathen and The Motley Fool have no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.

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