If you're an income investor, it's difficult to dislike Annaly Capital Management ( NLY 1.32% ). A pioneer of the mREIT business model, the industry giant owns a staggering $130 billion worth of domestic mortgages. It's the 800-pound gorilla in the room, outpacing its next largest rival, American Capital Agency ( AGNC 1.28% ), by nearly 50% in terms of mortgage holdings. And perhaps most importantly, it pays a whopping 13.4% dividend yield.
But sometimes, bad news can come in small packages. On Monday, Annaly announced that it submitted a bid to purchase the portion of Crexus Investment (NYSE: CXS), a much smaller REIT that focuses on commercial real estate, that it doesn't own already. Under the terms of the deal, Annaly will pay $12.50 a share for roughly 67 million shares of Crexus. The purchase price represents a 13% premium over the latter's preannouncement market value and a 5% premium over its most recently reported book value.
Examining the deal
The deal itself is relatively inconsequential. While Crexus' $968 million portfolio of commercial real estate assets may appear large, it's hardly even an afterthought compared with Annaly's $141 billion in total assets. Indeed, Annaly could buy Crexus with cold, hard cash and still have well more than $1 billion sitting in its bank account.
But the question is whether the tail -- that is, Crexus -- will eventually wag the dog -- that is, Annaly. Here's what Annaly's new chief executive officer Wellington Denahan had to say in a press release announcing the acquisition (emphasis added):
Since our inception in 1997, Annaly has maintained the capacity to diversify its asset base to include real estate related assets in addition to Agency mortgage-backed securities if we determined that compelling other long-term investment opportunities exist relative to the Agency market. While we remain committed to the Agency market, given the current environment, we believe it is prudent to diversify a portion of our investment portfolio. Therefore, we may allocate up to 25% of our shareholders' equity to real estate assets other than Agency mortgage-backed securities.
For clarity, I want to direct your attention to the italicized portion. It seems relatively clear that Annaly intends to diversify away from its sole focus on agency mortgage-backed securities -- and if the 25% figure is genuine, to do so in a major way.
So is this strategy good or bad?
There are several short-term advantages to the deal from the perspective of Annaly and its shareholders. Because Crexus is debt-free for all intents and purposes, its consolidation onto Annaly's balance sheet will lower both Annaly's leverage and its average borrowing cost. Also, because Crexus' commercial loan portfolio yields roughly four times that of Annaly's portfolio of residential mortgage-backed securities, or 10% compared with 2.5%, the deal will also be accretive to Annaly's net interest margin -- though only marginally, given the relative sizes of the companies.
Over the longer term, however, if the Crexus deal is more than just a one-off occurrence; it could very well change the entire risk profile of Annaly. Beyond its generous dividend yield, income investors love Annaly because it exposes them to essentially no credit risk, as its portfolio principally contains mortgage-backed securities that are guaranteed by Fannie Mae or Freddie Mac and, thus, presumptively by the federal government itself. Other types of assets, such as those in Crexus' portfolio, offer no such assurances.
The experience of Chimera Investment ( CIM 0.80% ) serves as a prescient example of how this changes the nature of an investment. Like Crexus, Chimera is a publicly traded real estate investment trust that's both managed by Annaly and invests in assets that aren't backed by the government. Because of the degradation in the value of Chimera's asset, however, its book value per share has declined considerably over the past two years, going from $3.59 at the end of 2010 to $3.08 today. Meanwhile, over the same time period, Annaly's increased by 8%, in no small part because it's insulated from credit losses.
The Foolish bottom line
At the end of the day, I can't help questioning the prudence of Annaly's decision, here. Sure, in the short term, I can appreciate its desire to increase its yield on earning assets and decrease its cost of funds. But to do so in a way that increases the risk to investors seems unnecessary and irresponsible.
To read more about the risks and opportunities facing Annaly, I encourage you to download our new in-depth report on the high-yielding mortgage REIT. In it, our senior financial analyst, Ilan Moscovitz, explains why it may be a solid income investment over the next few years but should be held with caution for a longer time period than that. To access this report instantly, simply click here now.