The mortgage real estate investment trust (REIT) sector has been a tough place to be over the past several months. A massive tightening of credit due to COVID-19 fears lopped sizable chunks out of book value and dividends for every stock in the sector. Now that the dust seems to have settled, the big question is: What now?
Here is what I am looking for when Annaly Capital Management (NLY 3.16%) reports second-quarter earnings in the coming weeks.
Annaly has reduced risk during the COVID crisis
Like every other REIT, Annaly reported a drop in book value per share for this year's first quarter (in Annaly's case, a drop of 22%, to $7.50). At that point, the mortgage-backed securities market was in utter chaos. Mortgage REITs were getting hit left and right by margin calls (demands for added cash to maintain compliance with repurchase agreement covenants). These margin calls forced everyone to sell mortgage-backed securities to pay back loans, and pretty much everyone was on the same side of the trade.
The chaos ended for the most part once the Fed stepped in to buy government-guaranteed mortgage-backed securities (called agency MBSes). However, mortgages without a government guarantee (known as non-agency) were not helped by the Fed's measures. Annaly holds both types of mortgage-backed securities, and during the first quarter it increased its exposure to government-guaranteed mortgages, a defensive move.
Instead of buying assets, Annaly is buying back stock
On Annaly's earnings call, the company made a surprising announcement: It was buying back stock. Since March 31, the company had bought back $100 million worth of stock. While some mortgage REITs were still selling assets (the non-agency REITs were still struggling with margin calls), and others were keeping dry powder and purchasing assets opportunistically, Annaly was buying its own stock. Essentially, Annaly is increasing its leverage. However, instead of borrowing money and purchasing assets, Annaly was increasing its leverage by buying its own stock at a discount to book value.
One of the numbers I am interested in will be the full-quarter stock buyback numbers, because it speaks to the opportunities in the mortgage market. On the conference call, CEO David Finkelstein said, "We are looking forward to transitioning from a defensive posture to a more offensive one but dislocations and constrained liquidity do persist and as a lever participant, we must remain focused on the stability of financing available for our investments and Agency MBS currently provides the most surety."
So Annaly is buying stock instead of buying assets. That means that many of the agency-specified pools are not cheap enough or liquid enough to gain much exposure. That is good news, as it means the selling is over, which is a positive for the whole sector.
Annaly trades at a discount to an increasing book value
The other number I want to see is the change in book value per share. Given that Annaly has been buying back its stock at a discount, book value per share should be increasing regardless of what asset prices do. That said, I want to see how much asset prices have recovered to get a sense of how much more potential increase there is in a return to normalcy. On the earnings call, CFO Serena Wolfe said: "Our book value decline was not a function of forced asset sales but rather unrealized mark-to-market losses with potential for recoupment." That 22% increase, along with the current 13% discount to book value, works out to a 35% potential return, along with a 13.6% dividend yield.
It is important to remember that mortgage REITs are not like other typical REITs, which make their money off rental income. The mortgage REIT sector holds securities, which are esoteric and can be hard to understand. These stocks do pay great dividend yields; however, they can be buffeted by market volatility. The worst of the bond market volatility seems to be over, and some of these stocks, like Annaly, will have a decent wind at their backs with interest-rate stability for a long time going forward. Annaly is one of my CAPS picks.