During Annaly Capital Management's (NYSE:NLY) third quarter conference call on Nov. 5, new CEO Kevin Keyes was asked: "Would it be reasonable for us to think that the largest growth opportunity over the next 12 to 24 months would be in these senior floating rate loans?"
Keyes responded: "Overall, I think you are exactly right."
The opportunity is commercial mortgage lending -- or loans to businesses for acquiring properties. This is a shift in strategy for the 18-year-old company that, before mid-2013, had never owned commercial investments. However, Annaly has aggressively grown its commercial portfolio to $1.9 billion -- or 15% of equity -- as of September 2015.
The change of direction and the pace of acquisitions makes it all the more intriguing to discover what is encouraging Annaly to join the ranks of mortgage REITs like Starwood Property Trust (NYSE:STWD) and pursue commercial investments.
They are floating rate loans
For starters, commercial loans often come with floating interest rates tied to a benchmark like LIBOR, or the London Interbank Offered Rate. This means that if the benchmark rate increases, then the interest rate on the loans will also increase.
In fact, according to Starwood Property Trusts CFO, Rina Paniry, if LIBOR increases by just one percentage point, he expects a $16.1 million benefit for the year -- or, $0.07 per share. Even better, LIBOR has historically followed the federal funds rate. This is the short-term rate that the U.S. Federal Reserve manipulates, and may begin to increase as soon as this December.
Unlike commercial debt, Annaly's traditional assets -- residential mortgage-backed securities -- have fixed interest rates. And these types of securities tend to get hammered in a rising interest rate environment. By investing in commercial real estate debt, it creates a natural hedge to help lessen the blow when rates rise.
Investing in commercial real estate may come with some benefits, but it is recent changes in banking regulations designed to help prevent another financial crisis that is really opening up opportunities.
The new rules impose stricter capital requirements for big banks. In short, banks have to hold a capital buffer, or a certain amount of liquid assets against their investments in case of defaults; the riskier the asset, the more liquid capital the bank needs to hold. This would tie up funds, and potentially make riskier loans like real estate construction and development loans not worth the price of admission and create opportunity for nonbank lenders.
Moreover, regulations could encourage banks to be generally more conservative with their lending, which creates opportunity in mezzanine lending.
For instance, if a bank makes a loan with a 65% loan-to-value (LTV), the borrower would be on the hook for the remaining 35%. To narrow the gap, the borrower could get mezzanine financing. This type of financing falls between debt and equity, and is backed by stock in a company rather than the real estate itself. Also, because the loan would be subordinate to the bank loan, it would be riskier, and come a higher interest rate.
This is an area that Annaly and Starwood Property Trust have been targeting. As of September 2015, mezzanine financing makes up 30% of Annaly's commercial portfolio and 21% of Starwood Property Trust's loan portfolio.
Wall of Maturities
Picking up the scraps banks leave behind isn't the only opportunity. Back in 2006 and 2007, a record number of commercial loans were made. Now it's 10 years later and it is predicted that more than $300 billion worth of commercial mortgage loans are maturing, per year, in 2016 and 2017.
The assumption is that this will create extraordinary demand for refinancing. The problem is that lending standards are tighter than they were before the financial crisis and not all these loans are going to be eligible for refinancing through traditional avenues. This should open the door to nonbank lenders like Annaly and Starwood Property Trust to get in the game.
Annaly's newest business
Commercial lending adds risk to Annaly's business. Unlike the company's traditional investments -- agency mortgage-backed securities, which were insured by the full faith and credit of the U.S. government -- commercial loans do default.
With that in mind, it will be interesting to see how aggressively Annaly pursues these investments and whether the company decides to make commercial real estate a larger and more permanent part of what it does. However, with this business line currently representing only 15% of equity, for now, commercial debt is simply a nice complement to Annaly's traditional business.
Dave Koppenheffer owns shares of Starwood Property Trust. 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.