For those looking to invest in real estate, but don't necessarily have a hoard of cash sitting on the sidelines, mortgage REIT PennyMac Mortgage Investment Trust (NYSE:PMT) may be just what you're looking for.
Not only does the company have a 55% total return since 2012, but most of that return comes in cold hard dividends. That's right, PennyMac Mortgage sports a monster 11%-plus dividend yield.
Unfortunately, though, dividends don't grow on trees. So, for investors interested in cashing in, understanding how PennyMac Mortgage operates is an essential first step to see if it is a real opportunity, or if that giant return is just a thing of the past.
What does it do?
Following the housing bubble, and eventual financial crisis, there was a sharp increase in mortgage defaults. This created a bit of a conundrum, because banks were desperate to dump their nonperforming loans.
But who would want to buy them? Enter PennyMac Mortgage in 2008.
The defaulting loans weren't necessarily "bad", they just need a little extra TLC. And considering how determined banks were to clean up their balance sheets, they were willing to sell the loans at a significant discount to principal value.
So, over the past five years PennyMac Mortgage has collected a ton of "distressed" loans. By using what it calls a "high touch" approach, the company has helped to restructure the mortgages to better suit homeowners. In successful cases, this can improve the credit quality of the loans enough to sell them for a profit.
PennyMac Mortgage is no one-trick pony, the company is also involved in correspondent lending and mortgage servicing. The process is below:
The original loans are made by correspondent lenders -- which are similar to brokers, except it underwrites the loan. From there, PennyMac Mortgage, or PMT, buys the loans, pools them, and sells them to a government agency like Fannie Mae, Freddie Mac, and Ginnie Mae (the process works slightly different for Ginnie Mae). In return, the company receives mortgage-backed securities, which represents the underlying value of the loans. Finally, it will sell these securities into the secondary market for (hopefully) a profit.
Equally important, the company retains the rights for servicing the loans, earning a fee acting as a middle man between the borrower and lender.
To qualify as a REIT, PennyMac Mortgage needs to distribute at least 90% of earnings.
On the plus side, the company receives favorable tax breaks, and the high payout is what creates the huge dividend yield. The downside, however, is the company needs to get a little more creative to fund its investments.
Repurchase agreements, or REPO loans, allow the company to sell assets to a lender with an agreement to buy them back at a later date. This frees up capital to fund additional investments, and since the process works similar to a collateral loan, PennyMac Mortgage can borrow at a low rate.
Using debt to fund investing does come with some risk. Much like putting down 10% (debt-to-equity ratio of 10) on a house that costs $100,000, if the house increases in value by 5%, your return on equity is a whopping 50%.
However, the problem is it works exactly the same in reverse.
But since PennyMac takes a fair amount of risk investing in distressed assets, the company is very conservative with its borrowing. In the first quarter it had a debt-to-equity ratio of just 1.7. This compares well to fellow mREITs Annaly Capital Management and Two Harbors' with debt-to-equity ratios of 5.2 and 3.4, respectively.
The bottom line
The incredible return and huge dividend yield are enough to draw interest from even the most pessimistic investor. However, the past doesn't always reflect the future, and that's why it's so important that you've equipped yourself with knowledge of how PennyMac Mortgage works.
Perhaps with more research, you'll decide to invest in this gaudy dividend payer. Top dividend stocks for the next decade
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Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.