2023-10-06 04:21:56 ET
Summary
- Annaly, a mortgage REIT, has seen a drop in valuation along with other income stocks, making it an attractive investment opportunity.
- The mortgage REIT has experienced a decline in operating performance due to rising interest rates, but the spread situation could improve going forward.
- Annaly's shares are currently priced at a discount to historical P/B and have potential for recovery, with potential upside of 14-20%.
Annaly ( NLY ) is a well-known mortgage REIT that has sold off together with other income stocks in recent days. Annaly has, in the past, cut its dividend in markets where (distributable) earnings were pressured and insufficient to support the payout, but I believe the current drop in valuation has gone a little bit too far.
After buying/adding other REITs such as W.P. Carey ( WPC ) and Medical Properties Trust ( MPW ) on the drop, I now bought Annaly as I believe the valuation is highly attractive, but I have done so chiefly because of Annaly's revaluation potential as its net interest spread returns to positive territory. Annaly, like so many other REITs at this time, is oversold based off of the Relative Strength Index!
Previous coverage
I covered Annaly more than two years ago and rated the mortgage REIT a buy , chiefly because I saw shares as a high-yield, long term bond option for investors with a desire for income. The mortgage REIT has recently (in FY 2023) seen unfavorable economic developments due to a rise in interest rates that caused its net interest spread to dip into negative territory. I believe the Fed will soon lower rates, which should turn out to be a catalyst for earnings growth.
Industry-leading mortgage REIT with considerable MBS portfolio
Annaly is one of the largest mortgage REIT investment options for dividend investors. The mortgage REIT generates value/income from its investments into a portfolio of agency mortgage backed securities that are core to Annaly's operations. Annaly's agency mortgage backed securities were valued at $71.6B at the end of June quarter and chiefly included long-dated (30-year) mortgages.
Annaly’s operating performance deteriorated rapidly as soon as the Fed raised interest rates last year, and the mortgage REIT is now in the peculiar situation of posting negative interest spreads for two quarters in a row.
The uptick in the Fed Funds rate resulted in a serious decline in the mortgage REIT’s net interest spread. In the June quarter, Annaly lost, for the second time, money in its business of investing in mortgage backed securities and disclosed a negative net interest spread of 0.73%.
FY 2023 | FY 2022 | |||
2nd quarter | 1st quarter | 4th quarter | 3rd quarter | |
Net interest margin | -0.15% | 0.09% | 0.65% | 1.42% |
Average yield on interest earning assets | 4.27% | 3.96% | 3.86% | 3.47% |
Average GAAP cost of interest bearing liabilities | 5.00% | 4.52% | 3.71% | 2.38% |
Net interest spread | -0.73% | -0.56% | 0.15% | 1.09% |
(Source: Author)
While this trend in Annaly net interest spreads is cause for concern, the fact that Annaly is losing money is likely going to be of temporary nature only. Interest rate increases have all but stopped lately and the Fed is aware that inflation is not as big a threat to consumers anymore as it was a year ago, indicating that the Fed will soon backtrack and help the economy by lowering interest rates. For Annaly, this would be a positive development and could, in my opinion, lead to a stabilization of the mortgage REIT's financial spreads, but also for its share price.
Annaly’s valuation relative to mortgage REIT rivals
Annaly has seen a large valuation drawdown of its shares in the last couple days… which in my opinion is related to the general weakness in the REIT sector. The industry is still reeling from higher than average interest rates which has had negative effects on Annaly’s earnings trajectory. However, I believe Annaly presents an attractive entry opportunity for investors that look for recovery potential.
Shares of Annaly are currently priced at a 16% book value discount. Annaly’s 1-year average price-to-book ratio was 0.98X, meaning investors were willing to value the mortgage REIT at about book value and the current valuation is a serious departure from the historical average. Right now, investors can buy Annaly at a 15% discount to the mortgage REIT's historical P/B ratio.
I believe, in the medium term (when interest rates converge on their long term average), Annaly could trade at book value again... which would give the mortgage REIT a fair value between $20-21 per-share. With a current share price of $17.48, a potential upside between 14-20% may be realized.
According to the Relative Strength Index, shares of Annaly are now also oversold (RSI value lower than 30, indicating technical revaluation potential)...
Risks with Annaly
There are a number of risks that investors must consider. First, Annaly’s (distributable) earnings are in decline and the mortgage REIT suffers a deterioration of its spread situation in a higher-rate world. Second, Annaly may cut its dividend. Third, Annaly may continue to trade at a large discount to book value for a while if the REIT carnage continues.
Final thoughts
I am not a big investor in the mortgage REIT space and have more focused on growth companies that have attractive potential for aggressive top line growth. However, the REIT sector is now where the real bargain are. While the dividend yield of 14.8% is eye-watering, I am not buying for income, I am buying because shares are trading significantly below the 1-year average P/B ratio. Therefore, NLY has recovery potential and I believe investors could see up to 20% upside within a year, not counting dividends.
I bought the drop yesterday because I believe the Fed’s upcoming change with regards to interest rates could result in a major re-rating of Annaly’s shares, Since shares of Annaly are oversold as well as undervalued (in my opinion), I believe the time is right to buy the drop!
For further details see:
I Just Bought Annaly Capital, But Not For The 14.8% Yield