Best REITs in Business

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

According to recent data by the Commerce Department, new home sales in the US are at their 3-year highs, rising by 20% in 2012. Moreover, the sales of pre-owned homes stood at 4.65 million, which is at its 5-year high. In my opinion, we can see continued growth momentum in 2013, especially since the Fed decided to inject $45 billion of additional liquidity every month. Moreover investor sentiment and consumer confidence is gradually recovering, which will further contribute to the real estate recovery. This presents a bullish case for REITs like Annaly (NYSE: NLY), Apollo Residential Mortgage (NYSE: AMTG), American Capital Agency (NASDAQ: AGNC) and Chimera (NYSE: CIM).

But there’s a roadblock

Savvy investors must know that the excess of liquidity in a low-interest rate environment has narrowed the gap between agency mREIT borrowing rates and the RMBS yield (Residential Mortgage Backed Securities). Naturally this puts pressure on the profit margin, as the company now have to leverage even further in order to retain their current profitability. This not only amplifies the rewards, but also risks. Moreover, the liquidity injections have pushed conditional prepayments higher, which further lowers the reward/risk ratio. So then where is the bullish case?

Smart moves?

In a market with intense competition and low margins, it’s always good to diversify and expand. Annaly already owns 12.4% of Crexus, and announced that it would acquire the remaining stake for $872 million. Crexus Investment is a commercial REIT, and this acquisition would allow Annaly to enjoy better spreads. But it should also be noted that Commercial MBS carry higher risks as compared to RMBS, which justifies the higher yield.

So basically, Annaly is moving away from a leveraged low-margin portfolio to high-margin/high-risk portfolio. Once this deal goes through, it will be interesting to see Annaly’s asset allocation pattern, which will hold the key to its reward/risk and risk management.

Shares of Annaly Capital yield a high 11.9%, with a high payout of 117%. Moreover its EPS over the last 5 years has averaged just around 5%. In a bid to reduce its dividend burden and boost its EPS, its board has approved a $1.5 billion buyback program.  At the CMP, this equates to a repurchase of around 99 million shares, and would lower its dividend burden by around 11.7%.

The prepayment game

As mentioned before, Constant Prepayments (CPR) steal away the rewards of holding risky assets by a REIT. Thus high CPRs are seen as a big negative in this industry, and Chimera is a classic example of that. Although its CPRs have declined by 3% YoY, it’s still a risky bet, as its quarterly prepayment rate is still towering at 19%. Even after a 20% reduction, its CPR would still be higher than most of its peers.

American Capital Agency, however, has a modest 10% CPR, which is close to the industry average. But its high PEG of 3x suggests that its shares are overvalued when compared to its growth prospects. Moreover, its high payout ratio of 144% with a debt/equity ratio of 700% suggests that dividend cuts might be around the corner.

But there’s a hidden gem: Apollo Residential Mortgage. Its low CPR of 5.4% for agency backed securities is perhaps the lowest in the industry. Moreover its high yield of 12.39% appears sustainable due to its modest payout ratio of 40% (according to Finviz). As on Sept. 30, its portfolio largely consists of agency backed securities (63%), while only 22% were non-agency MBS, and the remaining 15% was accounted by liquid positions. Non-agency backed securities have lower CPRs, but carry higher risk. But Apollo's portfolio allocation spreads its risks and rewards, and allows it to enjoy the best of both worlds. Moreover, its 15% cash allows the company to further leverage itself and boost its portfolio size.

Short conclusion

It’s not hard to conclude that Annaly Capital is a value play here. By repurchasing shares, it would not just support the price, but would also retain more of its earnings. But commercial paper is riskier, and investors looking to avoid this risk should invest in Apollo Residential Mortgage. Its low conditional prepayment risk makes it a safer bet and I think both companies are worth a Buy rating.


PiyushArora 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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