Hybrid mortgage real estate investment trust (REIT) company Two Harbors Investment Corp. (NYSE:TWO) reported fourth-quarter (non-GAAP) core earnings last week of $0.25 a share, which was well below the quarterly dividend of $0.40 a share it paid out. The company also reported a drop in book value per share from $14.72 at the end of the third quarter to $14.54. Falling interest rates increased prepayment speeds, which effectively lowers interest income going forward.
Two Harbors is a mortgage REIT, where much of its return to stock market investors is based on the dividend, so keeping a close eye on dividend coverage is critical. REITs have to pay out at least 90% of earnings for favorable tax treatment, which means there often isn't a lot of cushion. Whenever a REIT reports earnings below (or in this case substantially below) the dividend it is a potential red flag for a dividend cut.
So, is Two Harbors in danger of cutting the dividend? Let's take a closer look.
Management expresses support for the dividend
On the earnings conference call, Two Harbors CEO Thomas Siering addressed the issue of earnings and the dividend directly:
Core earnings was $0.25 per share as expected. It remains materially lower than our dividend. Echoing my comments from last quarter in certain rate environments, core earnings is not a good proxy for our dividend, rather, total economic return is a much more important metric, an indication of the ongoing earnings power of our company. We continue to be confident that our $0.40 [per share] dividend is supported by both the expected underlying earnings power of our portfolio as well as by taxable income generation.
The Hybrid REIT concept can generate odd results
Two Harbors refers to itself as a "Hybrid REIT," which means it invests in mortgage-backed securities and mortgage servicing rights (MSR). Mortgage-backed securities and mortgage servicing rights are a natural hedge for each other, in that when interest rates are falling, mortgage-backed securities will go up, while mortgage servicing rights will generally fall. Conversely, when interest rates are rising, mortgage servicing rights will go up while mortgage-backed securities fall. The goal of this strategy is to lower earnings volatility in order to maintain a stable book value per share.
Not all companies do this. For example, PennyMac has PennyMac Financial Services (NYSE:PFSI) which holds servicing and not mortgages, while PennyMac Investment Trust (NYSE:PMT) holds the mortgages but not the servicing. Many pure-play mortgage originators will do this since the value of MSR portfolio performs well in a rising rate environment, which is typically a bad time for the mortgage origination business.
In the fourth quarter, the rates environment was characterized by falling long-term rates, which caused higher coupon mortgage-backed securities to underperform relative to lower-coupon securities. Two Harbors adjusted its portfolio by selling some of the higher-coupon securities and buying lower-coupon securities. However, this negatively affected quarterly earnings.
Two Harbors often tells shareholders that it constructs a portfolio to perform well during most market environments and does not necessarily try to adjust its portfolio on a short-term basis. So, to the company's eyes, the portfolio is optimized to perform over the long haul, and it admits there will be quarters where the core earnings per share will come in well below the dividend issued. Is it necessarily an indication that a dividend cut is coming? If you are a shareholder, it's understandable that you might be concerned.
On an annual basis, Two Harbors' dividend looks better supported
But if you look at Two Harbors' annual numbers, the picture is much brighter. In 2019, the company paid out $1.67 in dividends and earned $3.09 a share in comprehensive income. Book value per share also increased from $13.11 to $14.54 per share. On a forward basis, the company's dividend of $1.60 works out to be a 10.5% yield, which is hard to find in this stock market.
Investors in hybrid REITs might be well rewarded for taking the long view on Two Harbors and tempering their reactions to short-term numbers that appear to be problematic. This company knows what it's doing and investors who understand that stand to benefit.