I have been very concerned about the real estate bubble that has formed during the pandemic and have closely followed its bursting. And AGNC Investment’s recent second quarter (“ER”) earnings report (NASDAQ: AGNC) and Annaly Capital (NYSE: NLY) has just provided more data to assess the degree of bursting. And unfortunately, I think it may get even worse from here.
Let’s start from a vantage point of 30,000 feet, as shown in the chart below, taken from Freddie Mac. Mortgage rates are currently at a level roughly equivalent to those seen from 2003 to 2007 before the Great Recession of 2008. Take the example of 30-year FRM rates, they have risen sharply from 3.01% there about 1 year ago at 5.3% currently.
Higher interest rates and higher borrowing rates hurt mREITs at least twice. First, they lead to higher borrowing for mREIT companies and reduce their profits. Second, demand for new mortgages is also weakening because higher rates make homes less affordable to potential buyers. AGNC and NLY report these impacts in their ER, unsurprisingly, as will be detailed in the next section. And I see both trends continuing in the near future.
Moreover, this time I also see that they are under pressure from two other directions. Record inflation will also make it difficult for EXISTING OWNERS to service their mortgages, creating the risk of defaults or even foreclosures. As a result, mREIT executives such as AGNC and NLY will experience book impairment losses. And the housing bubble unexpectedly created by the COVID pandemic will exacerbate the problem.
Let us now examine these impacts for NLY and AGNC in particular.
Affordability has declined
The impacts of rising rates and mortgage rates were already felt ahead of their Q2 ER. For example, the Mortgage Bankers Association (“MBA”) observed in early June that (emphasis added by me):
Weakness of both purchase and refinance requests causes the stock index to fall to its lowest level in 22 years. The 30-year fixed rate fell to 5.4% after three consecutive declines. While rates were still lower than they were four weeks ago, they remained high enough to continue suppressing refinancing activity.
And the results and comments from NLY and AGNC during their Q2 ER only added more data points to confirm the above observation. As NLY CEO David Finkelstein commented (abbreviated and underlined by me):
Home prices continued to risk heavily, appreciating more than 10% in the first five months of the year, according to the Case-Shiller index. However, housing activity has slowed recently, the highest mortgage rates since 2008 and a cumulative home price appreciation of 40%. since the start of the pandemic has weighed on consumer and automaker sentiment. Affordability for future homeowners has been significantly reduced, with mortgage payments being 50% higher year over year on the national average. This limits consumers’ ability to buy homes and therefore reduces demand for mortgages.
Namely, the monthly mortgage payment on the existing median was close to the $1,000 per month pre-pandemic level, as you can see in the following chart. It has risen sharply to the current level of almost $1,800 per month. In the past year alone, it has increased by around 51%.
Rising cost of funds and negative economic return
In addition to weakening demand for new mortgages and refinancing, rising rates are also hurting their profit margins. Take AGNC as an example, the following graph shows the average cost of funds over the past quarters. As you can see, its cost fund was 0.88% before the pandemic. Then it fell to practically 0 when the pandemic hit and the Fed had to implement a hard landing. It even benefited from two quarters of negative costs (meaning it was paid to borrow money) in the third and fourth quarters of 2021.
Then the music stopped and rates started to rise as the Fed had to fight inflation. In its Q2 ER, AGNC would have simply stated that its Q2 average cost of funds was 0.18%.
Now note that the Fed just hiked rates an additional 75 basis points after its ER. And the cost of 0.18% was before this increase. Therefore, investors should expect an even higher average cost of funds for the coming quarter. And I see a good chance of its cost of funds gradually returning to the 0.88% level.
And even at its current level, it is already showing negative economic returns as you can see in the following chart. Here, economic return is defined as the change in tangible net book value per common share plus declared dividends per common share. Its economic performance was -14.4% in the first quarter of this year and -10.1% in the last quarter.
NLY and AGNC: impairment losses
As mentioned above, besides weakening mortgage lending and rising borrowing costs, this time I also see NLY and AGNC hurting from two other directions. First, record inflation will also make it difficult for EXISTING HOMEOWNERS to service their mortgages. As National Association of Realtors (NAR) Chief Economist Lawrence Yun commented below (emphasis added by me):
The Russian-Ukrainian war and soaring fuel prices have helped make housing even more unaffordable for buyers. Compared to a few months ago, mortgages are more expensive for homebuyers. For a median-priced house, the price the difference is $300 to $400 more per month, which is a heavy toll on a working family.
Second, the pandemic has unexpectedly created a housing bubble. Demand has increased due to the need for remote employment. And the Fed’s landing led to historically low mortgage rates, further encouraging demand and driving up prices. Now that the trends in both the cost of borrowing and the demand for housing are beginning to reverse, it is very likely that the housing market will begin to see increases in loan defaults or even foreclosures, which which will lead to losses in book value.
And AGNC and NLY have already reported significant book value losses in the second quarter. For ANGC, its tangible net book value per common share fell to $11.43 from $13.12 last quarter, a loss of 12.8%. And for NLY, its book value fell by a similar amount, 13% this quarter.
Looking ahead, I see a great possibility that the loss in book value will continue or even worsen for the combination of the factors mentioned above (rising rates and increasing difficulty of affordability for new and existing home purchases ). Rising rates alone would result in huge losses, as shown in the table below. For a 75 basis point hike in interest rates (which the Fed just did after its ER), tangible common stock of ANGC would suffer a loss of 4.3%. And even for a shock of 10 bps in MBS shock, its tangible equity would suffer a loss of 6.2%.
NLY and AGNC: total shareholder return
Many mREIT investors are drawn to high dividend yields. Indeed, both currently offer high dividend yields. As you can see from the charts below, AGNC is earning 11.6% and NLY is earning 13.4%.
Here, I want to urge investors to also look at total shareholder return, not just cash dividend yield. In other words, shareholders should holistically consider the combined effects of cash dividends, book value gain/loss and stock dilution.
As just mentioned, AGNC lost 12.8% of its tangible book value in the last quarter alone, which is more than enough to offset its 11.6% full-year cash dividend. Historically, it has also lost book value (at around 6% per year since 2013). And he also diluted his shares at the same rate. Once these factors are taken into account, the current yield of 11.6% is not so attractive.
The picture is very similar for NLY. Again, its 13% book value loss in the last quarter nearly wipes out its cash dividend for the whole year. And historically, it has lost its book value by about 8.8% per year since 20 and diluted its shares by about 5.6% per year.
Final thoughts and other risks
When the above factors are taken into account, I consider the total shareholder return of AGNC and NLY to be unattractive, if not negative, going forward. Also, given the mentioned headwinds (higher rates, weaker demand and affordability risks), I see too much uncertainty for these stocks to sustain their current dividends. A dividend cut is a realistic possibility.
Further stock dilution is another possibility. And the dilution of shares to present values (by now both are already priced below book value) is very detrimental to total shareholder returns (at least for existing shareholders).