Investors are undoubtedly attracted to mortgage real estate investment trusts, or mREITs, such as Annaly Capital Management(NYSE: NLY), for their high dividend yields. Annaly, for its part, currently sports about a 13.2% yield.
Although investors might like these high yields, mREITs can sometimes be difficult to understand. With Annaly recently reporting its third-quarter results, let's look at the key metrics investors should pay attention to when considering investing in the stock and why there is a possibility the mREIT could raise its dividend at some point.
Key metrics
For nonprofessional investors, there are four key metrics I would focus on.
Book value: For an mREIT like Annaly, book value, by and large, represents the value of its investment portfolio, which is made up primarily of mortgages pooled together in the form of mortgage-backed securities (MBS). Annaly has also diversified into other assets, such as mortgage servicing rights, which, as the name suggests, give it the right to collect mortgage payments and handle customer accounts.
Book value is typically the metric on which mREITs are valued and, as such, is perhaps the most important metric to follow. Where an mREIT's book value goes, its stock tends to follow. Book value, meanwhile, is largely influenced by mortgage rates, which tend to move based on interest rates, as well as their yield relative to Treasuries.
Treasuries are considered essentially risk-free, and other fixed-income assets tend to have higher yields. This is often referred to as the yield spread, and it can narrow and widen based on different factors. When spreads widen because yields on fixed-income assets rise, their value tends to decline.
In the quarter, Annaly saw its book value rise to $19.54 per share, up from $19.25 last quarter and $18.25 a year ago. Its book value was under pressure before this year due not only to the Federal Reserve raising interest rates but also to yield spreads between Treasuries moving from historically low to historically high levels.
Net interest spread: The net interest spread is the difference between the yield of an mREIT's assets and its funding costs after hedges. Funding costs are typically variable-rate, short-term instruments, and mREITs usually hedge these to lock in the rate and increase their duration to better match the expected duration of their longer-maturity MBS positions.
Without these hedges, Annaly's funding costs would have exceeded the income generated from the assets in its portfolio. However, with hedges, Annaly's net interest spread was 1.32% in the quarter, up from 1.24% in Q2 and 1.18% a year ago.
Earnings available for distribution per share (EAD): This metric is the key to determining a company's ability to continue paying its dividend. Companies typically adjusts their earnings by removing non-cash items (like depreciation and amortization) and realized and unrealized investment losses. Essentially, it is looking to capture the income being generated by the business's investments, which is primarily influenced by its net interest spread and how much leverage it is carrying.
For Q3, Annaly generated $0.66 per share in income available for distribution, which was unchanged from a year ago when it carried more leverage. This income was just enough for Annaly to cover the $0.65 per share in dividends paid in the quarter.
Constant prepayment rates (CPR): Although the biggest risk to mREITs is higher mortgage rates, the companies are also exposed to prepayment risk when rates decline, which is when homeowners refinance into lower-rate mortgages or move and take on lower-rate mortgages. This is a risk because an mREIT would then have to replace that older, higher-yielding MBS with one that yields less.
In the quarter, Annaly saw its CPS tick up slightly to 7.6% from 7.4% in Q2. However, its projected long-term CPR jumped to 11.9% from 8.5% last quarter. This will happen when mortgage rates fall, but mREITs will typically take the trade-off that comes from increased book values that results from lower rates. The bigger risk would be for mortgage rates to suddenly plunge, which would lead to a lot more prepayments.
Image source: Getty Images.
Is Annaly a buy?
Although Annaly put up solid numbers, the company's management pointed to a number of potential catalysts, including a steeper yield curve, investor inflows, and an improving technical backdrop. The sector has had to deal with an inverted yield curve (when short-term rates are higher than longer-term rates) for two years, so the return of a more normal yield curve (when yields on long-maturity bonds are higher than on short-term debt) should help improve its spread income. In a more stable environment, it could also increase leverage to bolster this income.
While noncommittal, the company did say the current Fed plans to cut rates should be a good tailwind for its business and EAD and that a dividend increase was not out of the question. However, it said its biggest focus was on economic return, which is basically the combination of a growing book value and the dividend. That said, I think a steeper yield curve combined with slightly higher leverage could lead to higher EAD and an eventual small dividend increase down the road.
With the book value and dividend trending favorably in the sector, I'd buy Annaly stock.
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Geoffrey Seiler has positions in Annaly Capital Management. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
