The COVID-19 crisis has been the toughest test the mortgage real estate investment trust (REIT) sector has faced since the 2008–09 Great Recession. Liquidity in the mortgage-backed securities markets dried up virtually overnight, triggering margin calls and forced liquidation of assets. Every mortgage REIT reported big drops in book values and cut their dividends.
One mortgage REIT, Annaly Capital Management (NLY 1.59%), recently reported second-quarter earnings. What the company reported provides a snapshot of how things currently stand in the mortgage REIT market.
The worst is probably over for the mortgage REITs
Annaly Capital management said in their report that the worst is over as far as the financial fallout from COVID-19. While this ultimately depends on how the coronavirus pandemic progresses from here, management said the initial crisis is over and we are now in the recovery period, where asset values are returning to normal. On the earnings conference call, CEO David Finkelstein had this to say:
There have been some signs that the worst of the economic distress may be behind us, although with the recent surge in cases in some areas of the U.S. demonstrates the fragile nature of the recovery. Nevertheless, financial conditions have improved considerably. The market dysfunction that occurred amid the initial COVID outbreak in the U.S. has dissipated, and we have seen significant improvement in liquidity and asset pricing.
Agency securities were the first to recover
Annaly primarily invests in agency mortgage-backed securities, which are guaranteed by the U.S. government. These securities were the first to recover as the Federal Reserve began an aggressive asset purchase program in March, which continues today.
Annaly primarily invests in mortgage-backed securities, which have some characteristics that make them more attractive than the peer group. These securities (called specified pools) generally trade at a premium to their generic counterparts.
During the crisis, these pools traded at a discount to their peers; however, that valuation discount has largely been recovered.
Non-agency issuance will probably stall for a while
Turning to the non-agency side, net issuance of non-guaranteed mortgages will probably be negative for 2020. Mortgage originators have seen the market for non-guaranteed mortgages dry up and are feasting on easy refinance transactions, which is why originators like PennyMac Financial (PFSI 2.23%) are outperforming the markets. Annaly is still doing securitizations, and the fears about forbearance seem to be fading.
The commercial real estate portfolio performance was mixed, with hospitality and retail struggling, while multi-family and office properties are collecting over 90% of contractual rent. Commercial real estate generally accounts for about $2.5 billion of Annaly's $93 billion in assets, so it isn't a major component of the portfolio. Annaly also has other assets in mortgage servicing rights and middle-market lending. While Annaly does have some credit exposure, the vast majority of its assets are in government-guaranteed paper.
Annaly has been buying back stock at a discount to book value
Annaly reported a book value per share of $8.39, an increase of 11.9% from the March 31 mark. Net Interest margins (in other words, interest income minus interest expense divided by assets) widened from 0.18% to 1.89%. Leverage decreased from 6.8 times to 6.4 times. Given the stock's current discount to book value, Annaly has been buying back stock, purchasing $175 million in the stock year to date. This will be accretive to book value, even if the portfolio does nothing.
Annaly is trading at an 11.8% discount to book value, and it pays a dividend of $0.88 per share per year which works out to a yield of 11.9%. Historically, mortgage REITs generally trade on their dividend yields and stick close to book value.
Given the Fed's activity, interest rate volatility should continue to be muted, which is great news for investors in mortgages. Unless financial conditions take a dive or inflation returns out of nowhere, book value per share should slowly drift upwards, and the stock should slowly narrow the current discount. Between the discount and the annual dividend yield, this represents a potential return of 23.7% for the stock. Income and value investors should take note.