Investors are undoubtedly attracted to mortgages real estate investment trustsor mREITs, such as Annaly Capital Management (NLY -1.07%)for their high dividend yields. Annaly, for its part, currently has a yield of around 13.2%.

While investors may like these high yields, mREITs can sometimes be difficult to understand. As Annaly recently reported its third quarter results, let’s look at the key metrics investors should pay attention to when considering investing in the stock and why there’s a chance the mREIT could raise its dividend at a given time.

Key values

For non-professional investors, there are four key parameters I would focus on.

Book value: For an mREIT like Annaly, book value generally represents the value of its investment portfolio, which consists primarily of mortgage loans pooled as mortgage-backed securities (MBS). Annaly has also diversified into other assets, such as mortgage servicing rights, which, as the name suggests, give it the right to collect mortgage payments and manage customer accounts.

Book value is typically the value at which mREITs are valued, and as such is perhaps the most important metric to follow. If an mREIT’s book value goes up, its stock tends to follow. Book value, meanwhile, is heavily influenced by mortgage rates, which tend to move with interest rates as well as their yield relative to Treasuries.

Treasuries are considered essentially risk-free, and other fixed-income assets tend to have higher returns. This is often referred to as the yield spread and can narrow and widen depending on various factors. When spreads widen due to rising yields on fixed income assets, their value tends to fall.

This quarter, Annaly saw its book value increase to $19.54 per share, up from $19.25 last quarter and $18.25 a year ago. Its book value was under pressure before this year due to not only a Federal Reserve interest rates rising, but also yield spreads between treasuries moving from historically low levels to historically high levels.

Net interest margin: Net interest margin is the difference between an mREIT’s return on assets and its financing costs after hedges. Funding costs are typically floating-rate, short-term instruments, and mREITs typically hedge them to lock in the rate and increase their duration to better match the expected duration of their longer-maturity MBS positions.

Without these hedges, Annaly’s funding costs would have exceeded the income generated by its portfolio assets. However, with hedges, Annaly’s net interest margin was 1.32% in the quarter, up from 1.24% in Q2 and 1.18% a year ago.

Earnings available for distribution per share (EAD): This metric is key to determining a company’s ability to continue paying its bills dividend. Typically, companies adjust their earnings by removing non-cash items (such as depreciation and amortization) and realized and unrealized investment losses. Essentially, it tries to capture the income generated by the company’s investments, which is primarily influenced by net interest margin and how much leverage it has.

For Q3, Annaly generated $0.66 per share in distributable income, which was flat from a year ago, when it carried more lever. That income was enough for Annaly to cover the $0.65 per share dividend it paid in the quarter.

Constant prepayment rates (CPR): While the biggest risk for mREITs is higher mortgage rates, the companies are also exposed to prepayment risk when rates fall, meaning when homeowners refinance into lower-rate mortgages or move and take lower rate mortgages. This is a risk because an mREIT would have to replace that older, higher-yielding MBS with one that has a lower yield.

In the quarter, Annaly posted a slight increase in CPS to 7.6% from 7.4% in Q2. However, projected long-term CPR rose to 11.9% from 8.5% last quarter. This will happen when mortgage rates fall, but mREITs will usually take the trade-off that comes from the increase in book values ​​that result from lower rates. The bigger risk would be that mortgage rates would drop sharply, leading to many more prepayments.

Image source: Getty Images.

Is Annaly a buy?

Although Annaly delivered solid numbers, the company’s management pointed to a number of potential catalysts, including a steeper yield curve, investor flows and an improved technical context. The sector had to deal with a inverted yield curve (when short-term rates are higher than long-term rates) for two years, so the return to a more normal yield curve (when long-term bond yields are higher than short-term debt) should helps improve spread income. . In a more stable environment, it could also increase leverage to support this income.

While non-committal, the company said the Fed’s current plans to cut rates should be a good tailwind for its business and EAD, and that a dividend hike is not out of the question. However, he said the biggest focus was on economic yield, which is basically the combination of a growing book value and the dividend. That said, I think a steeper yield curve combined with slightly higher leverage could lead to higher EAD and possibly little dividend growth down the road.

Given that book value and dividends are trending favorably in the sector, I would buy Annaly stock.