The period from March through June was an incredible challenge for the mortgage real estate investment trusts (REITs). The COVID-19 crisis upended financial markets, particularly in mortgage-backed securities. The markets seized up and became illiquid, forcing just about every mortgage REIT to sell assets at a loss in order to meet margin calls from bankers. Eventually the Fed intervened, buying up massive amounts of agency mortgage-backed securities in an attempt to stabilize the markets.
Now that the dust has settled, most mortgage REITs look quite different than they did at the beginning of 2020. How did Redwood Trust (RWT +0.09%) fare?
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The non-agency mortgage REITs were hit harder
Redwood Trust is a non-agency mortgage REIT, which means it doesn't invest in securities guaranteed by U.S. government agencies. These mortgage REITs suffered the most during the pandemic because the Fed's buying did little to support their portfolios. Not only that, but the securitization markets, which Redwood relies upon to leverage its portfolio, dried up as well. In the aftermath of the crisis, mortgage originators focused almost entirely on government-backed origination. Redwood focuses on loans that fall outside of Fannie Mae, Freddie Mac, and government limits, which makes them harder to securitize or sell.
The jumbo mortgage space is only beginning to recover
Redwood's origination business focuses on jumbo mortgages, which are mortgages too large to be backed by the government, as well as business purpose loans for developers and professional residential investors. The jumbo space has begun to recover only recently, and Redwood purchased about $55 million in jumbo loans in May and June. During the second quarter of 2019, Redwood purchased about $1.6 billion in jumbos, so this is a significant drop-off. The decline was driven by banks massively tightening the credit box for any non-guaranteed loans. Business purpose origination grew from $175 million in the second quarter of 2019 to $234 million.
Business purpose lending yields high returns
The business purpose segment consists primarily of single-family rental loans and bridge loans. The single-family rentals segment is strong these days as people flee the cities for less crowded suburban environments, and single-family rental REITs like Invitation Homes and American Homes 4 Rent are experiencing strong demand. These loans generally have a five- to 10-year term. Bridge loans are generally for 12 to 18 months and are used to fix and flip properties or to fund rehabilitation before being replaced with permanent financing. The single-family rental loans generally yield around 5% to 6% while the bridge loans are 8% to 9%. Between the business purpose loans and the jumbo loans, Redwood collected 96% of payments in June.
The balance sheet shrinks
Redwood made some significant changes to the balance sheet during the quarter. It bought back its existing convertible bond, which actually created a gain for the company. Redwood also sold its pre-COVID-19 jumbo production and some of its whole loans. Marginable debt (which caused problems for the entire mREIT sector) fell from $3.5 billion to $375 million. Book value per share increased from $6.32 at the end of March to $8.15 at the end of June. The company estimates that there is approximately $3 per share in unrealized losses from the end of 2019 that remains on the balance sheet. In other words, as markets normalize, there is potential upside to book value as the non-agency space recovers and these loans continue to perform.
Overall, the underlying businesses should return to normal
The origination business will almost certainly recover as the low-hanging fruit of easy Fannie Mae and Freddie Mac refinancing becomes picked over. Most originators are only too happy to feast on these easy loans, and almost every banker is at capacity. Once that business starts to get back to normal, we will see more activity in the jumbo space. It is only a matter of time. The business purpose segment will continue to grow, and the demand for suburban residences only seems to grow as well. The underlying businesses for Redwood are fine.
Mortgage REITs are not for the faint of heart
Redwood is not for the faint of heart. For that matter, neither are most mortgage REITs. Mortgage REITs are complicated businesses, and the non-agency space can be subject to financial market storms that leave them illiquid and vulnerable.
Redwood was trading at an 11% discount to book value with a 7% dividend yield as of Wednesday's close. Is that the best that income investors can expect in this space? Well, AGNC Investment Corp. had a 14% discount to book value and a 10.4% dividend yield. AGNC invests almost entirely in mortgage-backed securities guaranteed by the U.S. government, which means the Fed's purchases are directly helping it.
While Redwood isn't bad, I don't think it is trading at a high enough yield (or discount to book) quite yet. Once jumbo origination returns to normal, and we start seeing some dividend increases, it might be worth a second look.
