On Wednesday, Federal Reserve Chair Janet Yellen said the central bank will keep interest rates very low for the foreseeable future, even after the economy recovers some more. This could have a tremendous impact on mortgage REITs like Annaly Capital Management (NYSE:NLY) which rely on interest rate stability to make money. Could this development give Annaly the shot of confidence it needs to boost its leverage once again? And what could this mean for investors over the next few years?
Uncertain rates are no good, but Annaly handles them well
When interest rates go up suddenly, it causes the spread between the interest rate mortgage REITs can borrow money for and the rate they collect on their investments to narrow. Since these companies are very highly leveraged to begin with, a spike in rates can drastically reduce their income.
Worse yet, a rate spike causes the mortgage-backed securities in the portfolio to be worth less, which can quickly erode book value and even lead to bankruptcy. Let's say one mREIT has $7 billion in assets, which it bought at a 7-to-1 leverage ratio, meaning the trust has $1 billion in equity. If the value of the assets drops by 20% due to a rate spike, this would be a loss of $1.4 billion, or more than the company's equity! This is why being highly leveraged is so dangerous in an uncertain rate environment.
Fortunately, Annaly's management has done a great job of adjusting to uncertain times, through both lower leverage and diversifying the portfolio. Commercial real estate now represents about 14% of Annaly's holdings, and the company has made it clear it plans to continue to grow this area of their business.
Annaly's leverage: now and what it could be
Some companies responded to the mREITs' discount to book value by buying back shares at a discount. While it's hard to argue with the logic of buying something for less than its worth, Annaly felt the best course of action was to keep leverage relatively low for the time being and to capitalize on new opportunities in a more stable rate environment.
Annaly's leverage ratio currently sits at 5-to-1, which is very low on a historic basis for the company, and even lower relative to most other mREITs. The company's leverage was about 7-to-1 in 2012, so around there would be a decent expectation if management feels rates are stable.
Annaly's CEO has already made her intentions clear. With new money spreads approaching 200bps, the company plans to significantly add to its positions as opportunities present themselves. To get back to 7-to-1, Annaly could purchase about $24 billion in new assets, meaning it has plenty of room to capitalize as conditions grow more favorable.
The dividend and Annaly's share price
If Annaly were to boost its leverage as mentioned; the company could increase its income and dividend by 40%, theoretically. This would represent a $0.42 quarterly payout, but let's conservatively say a $0.40 dividend is a reasonable target once leverage rises, as Annaly adjusts its payout in five-cent increments.
Now, Annaly's share price tends to gravitate toward a 12% annual yield, but adjusts to price in the possibility of increases or cuts in the dividend. For example, once the cut to $0.30 per quarter was announced in December, the share price immediately dropped to $10.00 per share. At $0.35 (September), we would expect about $11.67. Take a look at the chart and see for yourself where the price was, and how the yield hovers around 12% regardless of the dividend or share price:
Annaly currently has an annual yield of about 10.5%, which tells me the market thinks the dividend cuts are over and conditions are growing more favorable for mREITs to make money. At 12%, a $0.40 quarterly dividend corresponds to a $13.33 share price, which is a reasonable target if the Fed makes good on their pledge to keep rates low and stable.
Is this an even better investment than mREITs?
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Matthew Frankel owns shares of Annaly Capital Management. 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.