The Federal Reserve has been injecting $85 billion of liquidity every month and will continue to do so, until the unemployment rate falls below 6.5% and inflation is under control. To revive industrial growth and consumer spending, it has kept its long-term interest rates near to zero. This cheaply available credit in the economy has caused a spike in prepayments and narrowed interest rate spreads, which is contracting the margins of REITs
The prepayment game
According to recent data, Annaly Capital Management, Inc. (NYSE:NLY) has a prepayment rate (CPR) of 19%, while American Capital Agency Corp. (NASDAQ:AGNC), and Two Harbors Investment Corp (NYSE:TWO) reported CPRs of 11% and 6.6% (agency holdings), respectively.
Naturally, mREITs with the lowest prepayment rate would be considered to have the healthiest portfolio. With this filter in mind, Annaly Capital should be the riskiest bet among the three, but is it so?
Annaly Capital Management, Inc. (NYSE:NLY) owns a 12.4% stake in Crexus Investment Corp (NYSE:CXS) and has offered to buy the remaining stake for around $870 million. CreXus is a commercial REIT that deals with riskier assets, but enjoys better interest spreads. CreXus operates with a debt/equity ratio of 4 and enjoys a net profit margin of 73.47%.
I believe the acquisition would be great for Annaly Capital as its overall margins would expand and diversify its portfolio. Furthermore, Annaly Capital can use Crexus Investment Corp (NYSE:CXS)’s debt free balance sheet to raise some capital, and work towards lowering its conditional prepayments.
But the bottom line is that Annaly Capital Management, Inc. (NYSE:NLY) is moving towards riskier assets, hunting for margin expansions. That puts American Capital Agency Corp. (NASDAQ:AGNC) and Two Harbors Investment Corp (NYSE:TWO) in a relatively safer spot, which primarily deal in federally backed securities.
So Annaly or not?
Furthermore, until the acquisition of Crexus Investment Corp (NYSE:CXS) is complete, Annaly won’t get a boost in its net income, and at the current levels, its dividend payouts seem unsustainable. According to analysts at Nomura, Annaly Capital should cut down its quarterly dividends to $0.3, which would be more realistic and sustainable.
At current prices, shares of Annaly Capital Management, Inc. (NYSE:NLY) yield 11.3% while American Capital Agency Corp. (NASDAQ:AGNC) andTwo Harbors Investment Corp (NYSE:TWO) yield 15.25% and 10.55%, respectively. Income investors should definitely consider investing in American Capital since it not only has a higher yield, but also since its lower CPR seems to have stabilized at 11%.
That said, American Capital enjoys a net profit margin of 60.53% as compared to Annaly Capital’s 53.26% and Two Harbors Investment Corp (NYSE:TWO) 63.26%. Since Annaly Capital has over $130 billion in assets, I don’t think the acquisition of Crexus Investment Corp (NYSE:CXS) would put Annaly at par with American Capital in terms of margins. Additionally, shares of American Capital appear to be the most undervalued with a forward P/E of 7.9, as compared to Annaly’s 10.9 and Two Harbor’s 9.12.
What’s in store
The 15-year and 30-year mortgage rates have risen 1.5% and 4.4% over the last 6 months, respectively. Naturally, if the rates are high, people would be less inclined to prepay or refinance their loans. This should either stabilize, or maybe even reduce the prepayment rates.
Moreover, the Fed’s members are hinting at slowing down the monthly liquidity injections, which could be a huge relief for REITs. Even a temporary pause in QE3 should boost the 15 and 30 year yields, and effectively expand the interest rate spreads. Its not hard to conclude that we could be looking at margin expansions here.
In my opinion, both American Capital Agency Corp. (NASDAQ:AGNC) and Two Harbors Investment Corp (NYSE:TWO) are great stocks to hold, but Annaly Capital Management, Inc. (NYSE:NLY) entails greater risk.
Piyush Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.