Last year was awful for the mortgage sector as the Fed bumped up interest rates to get inflation back under control. Mortgage originators suffered as volumes declined and mortgage real estate investment trusts (REITs) saw their holdings underperform Treasuries, which led to declines in book values.
The worst of the situation seems to be over, as mortgage-backed securities are outperforming Treasuries again. Annaly Capital Management (NLY 1.13%) is one of the best-run mortgage REITs out there, but the current high dividend yield should be viewed with caution. Here's why.
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Mortgage REITs are different from traditional REITs
The typical REIT develops real estate properties like office buildings, shopping malls, or apartment buildings and then rents out individual units. Mortgage REITs don't invest in real estate; they invest in real estate debt (in other words, the mortgages themselves). While most REITs follow a landlord/tenant model, mortgage REITs generally look more like a hedge fund or a bank.
Annaly invests in mortgage-backed securities, which are guaranteed by the U.S. government, and they account for about two-thirds of Annaly's investment portfolio. If you recently bought a house with a mortgage backed by Fannie Mae or Freddie Mac, chances are it ended up in a mortgage-backed security that might be held by a REIT like Annaly. If the borrower skips a payment, the government ensures that Annaly still gets paid. These securities have minimal credit risk, but they are subject to a lot of interest rate risk.
The second asset class Annaly owns is non-agency mortgages, which are not guaranteed by the U.S. government. These generally pay higher rates, but Annaly is subject to loss if the borrower defaults. Non-agency residential credit accounts for about 19% of Annaly's portfolio.
Mortgage servicing has been the star of 2022
The rest of the portfolio is invested in mortgage servicing rights, which are an unusual asset. Mortgage servicers perform the administrative tasks of managing a mortgage on behalf of the investor in a mortgage-backed security. The servicer sends out the monthly bills, collects the payments, sends the payments to the investor, ensures property taxes are paid, and works with the borrower in the event of default. The servicer generally receives 0.25% of the outstanding principal balance of the mortgage as compensation.
In other words, if the mortgage is $800,000 the servicer gets paid $2,000 per year. The right to perform this function is worth something, and it is capitalized on the balance sheet as an asset.
Last year was difficult for agency mortgage-backed securities as the Fed raised rates to beat inflation. Mortgage-backed securities fell in value as rates rose, and the performance on their hedge positions didn't make up for the losses. This is why we saw declines in book value per share across the entire sector. Annaly's book value per share at the end of 2021 was $31.88 before falling to $19.94 at the end of the third quarter of 2022. Book value rebounded to $20.79 in the fourth quarter as mortgage-backed securities began outperforming Treasuries.
Servicing income rose throughout the year as the portfolio grew and servicing valuations responded positively to rising interest rates. Servicing assets have been the one bright spot for mortgage originators this year, although the big increases in valuations are probably over at this point.
Annaly is valuing its servicing portfolio at 5.25 times the annual servicing fee. This is about where it valued servicing in the first quarter of 2022. This is more conservative than some other REITs that are valuing their servicing quite aggressively. The risk of an aggressive servicing valuation is that multiples can contract, which means writedowns in the future.
A recession is a risk for Annaly Capital
If the U.S. enters a recession in 2023, servicing income will almost certainly fall as defaults pick up. Rising defaults mean rising servicing costs and lower servicing income. The higher the servicing costs, the lower the valuation as well. The residential credit portfolio will also suffer if defaults rise, but more if real estate prices fall.
Falling real estate prices encourage strategic defaults, which is what happens when the underlying property value falls below the amount owed on the mortgage. Investors in a rental property might decide to simply toss the keys to the bank and walk away.
Annaly had funds available for distribution of $0.89 per share, and the quarterly dividend is $0.88, so Annaly doesn't have much margin for error if a recession hits servicing income and defaults increase. Annaly is trading at a small premium to book value per share and I generally like to pick up mortgage REITs at a discount. The dividend yield is pretty high at 16.2%, but that reflects the possibility of a cut if things turn south for the economy. Annaly is a great mortgage REIT, but the dividend is no sure thing.
