Though the sector was hit hard by the financial crisis of 2008, Annaly has managed to maintain its profitability and its stock has been remarkably stable with low volatility and a Beta of just over 0.2. Before I go any further, let me explain how the REIT business model operates. Essentially, they arbitrage the interest spreads between low-cost short-term borrowing rates and the higher long-term interest rates to be from investments such as mortgage-backed securities. The difference between the cost of borrowing to buy securities and the returns on these securities represents the revenues and the law requires that REITs should pay dividends amounting to 90% of their earnings. A high spread therefore creates the opportunity for investors to earn high yields. As a result, returns on listed REIT stocks outperformed the S&P 500 considerably with returns being in the region of 400% higher than returns on the market as a whole. This has also been made possible because of the low interest rate climate that has been the policy of the Fed. Annaly stock is currently priced at close to its book value and produces a dividend yield of around 14%. Annaly is also the largest REIT in the country with a market cap in excess of $15 billion and a mind-boggling operating margin of just under 70%.
With all these factors taken into account, let us turn our attention to the pros and cons of investing in REITs in general and Annaly stock in particular. One of the reasons for the superior performance of the sector in general has been that short-term borrowing costs have fallen more quickly than returns on long-term investment resulting in increased generation of free cash flows. However, in 2011, we are beginning to see signs of a reduction in the spreads that are earned by Annaly and this finding is applicable to the REIT industry as a whole. I would surmise that the beginning of the squeeze on margins is the result of declining long-term returns with no little or no scope for borrowing costs to drop any further. Leverage is an important part of the business and it is difficult to reduce borrowing costs. On the flip side of the coin, investment portfolios like the Annaly portfolio may be better hedged for risk but this very factor imposes limitations on increasing the spread without taking on higher risk assets.
I should point out that yield investing is essentially a long-term process which involves a buy and hold strategy so stock fundamentals are important. This could involve buying stocks with stable dividends that have prospects of increasing dividends. A stock like Annaly that returns a yield in excess of 14% annually could well be perceived by conservative investors as high risk because they do not know how to manage the risk. The risk can be managed if you understand that the REIT business simply consists of borrowing money at low interest rates to invest in securities or assets that pay out more. Success in the future consists of the ability to continue doing so. Another factor that affects the dividend is the rate of mortgage prepayment because prepayments have to be reinvested in assets often with lower yields.
There is no real competitive advantage in the REIT business so fundamentals and track record are critical to choosing the stock for investment. There is some information to be gained from looking at other stocks in the same industry. Equity Residential Company is about the same size as Annaly when it comes to market cap but the stock price is more volatile than Annaly because of its Beta of 1.17. However, it has a much lower operating margin and the dividend yield is only about one-tenth that of Annaly which naturally has much stronger cash flows. CYS Investments (NYSE:CYS) has a comparable yield of around 15% as does Armour Residential REIT (NYSE:ARR) at around 18% but Annaly is the best managed of these companies and has an outstanding track record of maintaining dividend payments over a decade.
The interest rate regime in the U.S. is likely to continue into 2013 (judging by the pronouncements of the Fed) and there is no reason that I can see why Annaly should not maintain its dividend record at least till then. In my opinion, the yield and the current level of the stock price should justify an investment and I would recommend a buy. However, if you are an existing investor or if you still have your reservations about real estate investment, I would watch the trends in interest rates closely. Attractive buying opportunities should make themselves available at every decline in the stock price.