Life has been difficult for companies in the mortgage industry over the past 18 months. The Federal Reserve has been aggressively hiking interest rates to damp inflation, reducing the value of fixed income securities including mortgage-backed securities (MBS).
That has translated into declining book values for mortgage real estate investment trusts (REITs), which invest in the securities. One of them, Annaly Capital Management (NLY 1.38%), just reported second-quarter earnings. Is the stock a buy?
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Mortgage REITs have a different business model than typical REITs
Mortgage REITs are different from the typical REIT. Most REITs follow a landlord/tenant business model. They develop properties and then rent out the space.
Mortgage REITs don't buy property, for the most part. They buy mortgages, and instead of collecting rent, they collect interest. In many ways, mortgage REITs more closely resemble a bank or a hedge fund.
Annaly Capital has three basic investment strategies: agency, residential credit, and mortgage servicing. The agency strategy involves buying mortgage-backed securities, which are guaranteed by the U.S. government. If you recently bought a house with a mortgage guaranteed by Fannie Mae or Freddie Mac, chances are it could possibly have ended up on the balance sheet of a REIT like Annaly.
Mortgage servicing is an unusual asset
The mortgage servicing strategy is an unusual business. Servicers handle the tasks of administering the mortgage on behalf of the ultimate owner of the loan. The mortgage servicer sends out the monthly bills, forwards the principal and interest to the investor, and works with the borrower in the event of default.
The mortgage servicer is paid 0.25% of the mortgage principal amount as compensation. The right to perform this service is valuable and is capitalized as an asset on the REIT's balance sheet.
The residential credit business involves originating mortgage loans that are not guaranteed by the government. These loans are generally made to professional real estate investors, not to the typical homeowner. They carry higher interest rates than government-guaranteed loans, and Annaly earns fees to originate them.
Annaly's portfolio of strategies is meant to diversify risk
Annaly's three strategies are intended to have a diversification effect. When mortgage rates are rising, the agency strategy will struggle as it has over the past 18 months. On the other hand, mortgage servicing rights respond favorably to rising interest rates. This has worked out reasonably well over the past three quarters, with Annaly's book value per share declining only slightly from $20.79 to $20.73.
The second quarter was characterized by increased underperformance by mortgage-backed securities amid higher interest rate volatility. Earnings available for distribution still covered the dividend in a difficult environment. Annaly said on the earnings conference call that it sees a more benign environment for agency mortgage-backed securities in the second half of the year.
Wait until the Fed is done hiking rates
Annaly trades at a 4% discount to book value per share, with a dividend yield of 13.1%. Once the Fed is finished with its tightening campaign, we should see improving mortgage-backed security performance, which will help push up book value per share.
That said, as long as the Fed is hiking rates, it is hard to get too excited about Annaly Capital. Once the Fed signals that the final rate hike is in the books, the REIT might be worth buying. Until then, it isn't cheap enough yet.
