How Will the Upcoming Fed Meeting Impact REITs?

Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Fed Chairman Ben Bernanke is scheduled to meet with his fellow policymakers soon to consider whether or not they should continue with quantitative easing. The results of their deliberations could have a profound impact on the mortgage REIT industry and the largest mortgage REIT Annaly Capital Management (NYSE: NLY). The debate on when to end bond purchases is continuing, but the U.S. labor market has not yet shown any signs of the significant gains the Fed would like to see before ending the program. While unemployment continues to hover around 7.8%, where it has been since the beginning of 2009, the Federal Open Market Committee does not envisage an immediate threat from inflation, which currently stands at 1.4%.

At least two district bank presidents who support the record quantitative easing have voting rights this year, while six Fed officials have shown their willingness in allowing the bank to continue easing.  It is therefore likely that the Fed Chairman can count on the FOMC to support the current programs of buying $40 billion in mortgage backed securities and $45 billion in treasuries every month.  The U.S. Agency mortgage REITs have been hit by the third round of QE 3, and the squeeze is likely to continue.

Impacts On Annaly

At the end of the third quarter, Annaly's portfolio was made up of 93% fixed rate mortgage backed securities, while the remainder was adjustable rate securities. The average maturity of the company’s securities was 4.93 years, while the conditional prepayment rate increased from 19% to 20% at the end of the third quarter.  Because of the quantitative easing program, Annaly saw a 52 basis point decline in its annualized interest rate spread year over year and, as a result, it was forced to slash its quarterly dividends by 10% to $0.45 per common share.

Meanwhile, Annaly has been reiterated by TheStreet Ratings as a buy with a ratings score of B-. The firm's impressive growth in net income, attractive valuations, strong cash flow from operations, and growth in earnings per share are seen to outweigh the fact that the company's stock has shown lackluster performance.  The analyst points out that net income growth from the corresponding quarter of the previous year is well in excess of that of the S&P 500 and the Real Estate Investment Trust (REIT) industry. The net income increased by 124.4% when compared to the same quarter one year prior, rising from -$921.81 million to $224.76 million.  Net operating cash flow has significantly increased by 115.73% to $3,597.99 million when compared to the same quarter last year, which is well in excess of the industry average cash flow growth rate of 13.48%.

Outlook

Lets take a quick look at the positive and negative factors that are likely to affect fourth-quarter performance as well as the outlook for 2013. All mREITs are currently experiencing a number of problems, of which the biggest is the third round of quantitative easing by the Fed. Although the increased demand in the mortgage backed securities market has had a positive effect of increasing the value of the securities held by Annaly, it has also had the negative effect of squeezing the interest spread on its portfolio. 

This has been particularly harsh on mortgage REITs with high constant prepayment rates, and as a result Annaly has the highest CPR and the lowest interest rate spread compared to its peers.  The company has taken steps to counter these problems by reducing the cost of funds, which has been achieved by the issue of preferred shares and the restructuring of its liabilities for a longer duration.  It also proposes to diversify by acquiring CreXus Investment, a REIT that focuses on commercial property and has a higher yield on its portfolio.

The second half of 2012 has resulted in the flattening of the yield curve as a result of the initiatives of the Fed. However, average fixed mortgage rates have edged higher recently. The 30-year rate averaged 3.4%, the highest in eight weeks, and above the previous average of 3.34%. The 15-year rate averaged 2.66%, up 2 basis points from its previous average of 2.64%.

Mortgage application activity also showed an increase of 11.7%, while refinancing applications increased 12%.  This indicates that we may well see a steepening of the yield curve in 2013.  This can only benefit companies like Annaly, which could see improved interest spreads.

Peers

American Capital Agency (NASDAQ: AGNC) owns a majority of fixed rate securities, and approximately 63% of the company’s MBS portfolio consists of 30-year fixed rate securities, while 32% is 15-year fixed rate.  20-year fixed MBS is 3% of the entire MBS portfolio of the company at the end of the third quarter of 2012. The average maturity was 4.3 years, while the CPR rate was 9%. However, the prepayment protected portfolio enabled American Capital to continue its quarterly dividend of $1.25 per common share.

Armour Residential (NYSE: ARR) invests exclusively in Agency mortgage REITs, 90% of which are fixed rate securities, and 10% are ARMs and Hybrid ARMs. The company is largely invested in 15 and 20-year MBS, with low coupons and loan balances, making them prepayment protected. Armour reported 13% CPR at the end of the third quarter. 

Two Harbors has recently spun off its single-family home portfolio into a new REIT named Silver Bay Realty Trust. The housing bust, which has had a detrimental effect on mortgages and interest, has turned into a major business opportunity for entities like Silver Bay. Private investors have snapped up distressed single-family homes cheaply and the glut of foreclosures has resulted in a new industry in which single-family rentals are becoming the new norm.

Conclusion

Annaly is currently available at an attractive valuation at a discount of around 11% to its book value, and you must remember that the book value is established by marking the portfolio to market so that the value is realistic.  It is a most attractive income investment with a dividend yield of a little over 12%, and you can expect the dividend to continue to be attractive at least until the end of 2014.  In the current environment of rock-bottom interest rates, mortgage REITs are among the best income investments, and Annaly is the largest and arguably best managed REIT.  If you are looking for income, I recommend taking a closer look at Annaly.


jordobivona has no position in any stocks mentioned. The Motley Fool owns shares of Annaly Capital Management. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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