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Is Redwood Trust a Buy at a Discount of More Than 20% to Book Value?

By Brent Nyitray, CFA - Mar 19, 2020 at 1:40PM

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When gauging fallout from the coronavirus, Redwood's business model is more stable than a typical mortgage REIT's.

The novel coronavirus pandemic sell-off has created some opportunities in the overall stock market as entire sectors have been thrown overboard in the wake of worldwide reaction to the COVID-19 disease. The mortgage real estate investment trust (REIT) sector has not been immune to the adverse effects.

Redwood Trust (RWT 4.11%) has been sold to the point where it is trading at a discount to book value of over 20%, and it has a 10% dividend yield. Is this an opportunity to buy at a discount? 

Redwood Trust is primarily a lender

Redwood Trust has four main verticals: residential lending, multifamily lending, business purpose lending, and third-party lending. The residential lending vertical focuses primarily on high-quality home loans that are too large to be guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac. These loans (generally called jumbo mortgages) are highly conservative, and those receiving them have substantial equity and high credit scores. The business purpose lending segment finances professional rental investors. Through the recent acquisitions of CoreVest and 5 Arches, Redwood has become one of the top business purpose real estate lenders in the U.S.

Picture of a mortgage

Image source: Getty Images.

Residential lenders are finding themselves pretty much at capacity right now, and there is still a huge demand for loans. The massive drop in interest rates caused by concerns regarding the coronavirus caught the industry completely off guard, and nobody is staffed for this amount of volume right now. Redwood management noted on its fiscal 2019 fourth-quarter conference call in late February that the bigger banks are raising lending margins (in effect raising prices), which is making Redwood more competitive. 

Interest rate effects, credit risks, and valuation

While falling interest rates can be an issue for an agency mortgage REIT that buys and holds government-guaranteed mortgage-backed securities, Redwood has a different business model. Redwood is primarily a lender and will benefit from falling rates because it will increase residential loan volumes. The Mortgage Bankers Association recently raised its forecast for 2020 originations by 20% to $2.6 trillion. While falling rates can harm a mortgage loan portfolio and the associated mortgage-servicing rights, the lending arm acts as a natural hedge. Redwood is more exposed to an increase in interest rates, not a decrease. 

Last year, Redwood purchased $5.9 billion in loans, securitized $1.9 billion, and sold $3.2 billion to third parties. The vast majority of Redwood's residential production is not held as a long-term investment, which reduces its exposure to interest rate fluctuations. The lending arm is a cash-generating machine, which supplements investment income. 

Unlike many of its mortgage REIT peers, Redwood is not in the agency mortgage investing space. This means that if borrowers default on their loans, ultimately Redwood bears that loss. Fortunately for Redwood, the state of the residential real estate market is robust. The U.S. has a shortage of housing units, which means valuations are well supported by supply and demand. This means the underlying collateral for the loans should hold up, even if the borrower defaults. Further, the big drop in interest rates will support real estate valuations as it improves affordability. The business purpose loans have higher interest rates as well as prepayment penalties, which protect the lender when rates fall quickly. Prepayment penalties are prohibited for most residential mortgages. 

Redwood's book value per share at the end of 2019 was $15.98. As of Friday, March 13, the stock was trading at $12.56, which gives it a discount to book value of 21%. The company also increased its quarterly dividend to $0.32 per share, which works out to a 10% dividend yield. Last year, Redwood paid out $1.20 a share in dividends on $1.46 in net income per share, which means the dividend is well supported. 

Redwood is not an agency REIT

Many mortgage REITs have been thrown overboard in the current sell-off, and for good reason. Mortgage REITs that invest primarily in government-guaranteed mortgage-backed securities have massive interest rate risk. To generate an acceptable return, these companies need to use a fair amount of leverage. The difference between interest earned on the securities and interest paid on the borrowings is small, so it doesn't take much of a shock to knock out that spread. These stocks have a higher risk to book value, as the highest-paying securities are being paid off early, which will create valuation writedowns. Redwood, on the other hand, has a fee-generating lending business that supplements the investment business. Its book value and dividend are much more secure than the ultra-leveraged agency REITs.

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