Gillian Tan is a Bloomberg Gadfly columnist covering deals and private equity. She previously was a reporter for the Wall Street Journal. She is a qualified chartered accountant.

Investors in Annaly Capital Management didn't take too kindly at first to Monday's news that the real estate investment trust had struck its biggest deal yet: Shares of the company, which invests in mortgage debt, fell as much as 2.4 percent. By afternoon, shareholders were starting to come around and the stock had mostly recovered -- for good reason. 

Annaly is buying Hatteras Financial, a smaller REIT that buys mortgage debt, in a cash-and-stock deal valued at $1.5 billion. The acquisition, which is expected to be accretive immediately, shouldn't come as a surprise considering Annaly has been vocal about its desire to diversify and shed a longtime focus on government-backed mortgage debt. Those securities, known as agency MBS, come with low risk but also lower returns than so-called hybrid adjustable-rate mortgages (or ARMs) which benefit when interest rates rise. 

Time for Change
Annaly's purchase of Hatteras will decrease its reliance on fixed rate government-backed MBS.
Source: Bloomberg, company filings

Buying Hatteras will help reduce Annaly's concentration on government-backed debt to roughly 80 percent of its portfolio, enabling it to quickly reach the 77 percent target set by its board in February as part of a diversification plan and improve the stability of its earnings.  

The firm's decision to finance the deal predominantly with stock (65 percent versus a 35 percent cash component) is wise, considering it has outperformed Hatteras over the past year, in part due to a still-in-progress $1 billion share buyback. It also keeps a lid on leverage, leaving the combined entity with a debt pile worth roughly 6.7 times its earnings. That means there's room for additional borrowings that could fund future acquisitions.

Opportune Timing
Annaly's share outperformance lends credence to the heavily-weighted stock component of the deal.
Source: Bloomberg

Monday's deal structure leaves Annaly, the biggest of its peers with a market value of $9.6 billion, well placed to pounce again considering other residential mortgage REITs are trading at around 70 percent of their book value, according to analysts at FBR & Co.   On the flip side, Annaly is trading at roughly 89 percent of its book value. 

Bargain Buys?
Mortgage REITs have declined as a group over the past year, making laggards more vulnerable to consolidation.
Source: Bloomberg

Annaly's announcement sent shares of Two Harbors Investment, AG Mortgage Investment Trust and CYS Investments up nearly 2 percent each, while movements in the shares of Starwood Property Trust, Redwood Trust and New Residential Investment were less bountiful. Analysts at Keefe, Bruyette & Woods see potential tie-ups between American Capital Mortgage Investment and American Capital Agency as well as Ellington Residential Mortgage REIT and Ellington Financial. 

The mortgage REIT universe is relatively small and Annaly has its hands full bringing the Hatteras deal to a close (not to mention integration). But Annaly CEO Kevin Keyes has left the door open to more dealmaking. "There's plenty of opportunities out there...especially for us," he said on a call with analysts Monday.

Looks like Annaly's biggest deal won't be its last. 

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. Monday's deal values Hatteras at 85 percent of its last-reported (Feb. 29) book value. 

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