These have been trying times for mortgage real estate investment trusts (REITs). Nearly all of them were forced to sell assets at reduced prices in an illiquid market this spring. All reported big declines in book value per share and dividend decreases. And some embarked on wholesale business changes.
New Residential Investment Corp. (NYSE:NRZ) was one of them, but that's not the only change investors should consider now. New Residential was known for non-guaranteed mortgages, but it made a switch to focus on mortgages guaranteed by the government. At the same time, we have some interesting new perspective on its mortgage origination and servicing business thanks to a few recent initial public offerings in the industry. Add it all up and New Residential becomes an interesting sum-of-the-parts story.
On New Residential's earnings call, management recognized that the market is really not assigning much value to the origination arm, and the company would consider an array of options in determining how to unlock value. What does that mean for investors?
Mortgage servicing runoff takes a bite out of book value
Let's start with a quick look at New Residential's latest earnings. For the quarter ending Sept. 30, New Residential reported earnings of $0.19 per share by generally accepted accounting principles. It also delivered $0.31 per share in core earnings, a non-GAAP measure that excludes realized and unrealized gains. The quarterly dividend was raised 50% to $0.15 per share. Book value per share increased to $10.86 from $10.77 in the second quarter. While the origination and servicing business earned $0.82 per share, mortgage servicing rights amortization decreased book value by $1.23. Meanwhile, the investment portfolio earned $0.75 per share.
Mortgage servicing rights are somewhat unusual assets. Essentially, the mortgage servicer handles all of the administrative tasks of the mortgage on behalf of the investor. The servicer collects payments from the borrower, sends the principal and interest payment to the investor, ensures property taxes are paid, and deals with the borrower when he or she defaults on the loan. The servicer generally earns about 0.25% of the loan balance each year as compensation for this service. The mortgage servicing right is generally valued as a multiple of the annual servicing payment.
Mortgage servicing rights are one of the few financial assets that increase in price as rates rise. This means that mortgage servicing rights act as a natural hedge for the mortgage origination business. When rates are low, borrowers are refinancing their current mortgages to save money. This means the mortgage operating business should be booming, which it is. This is negative for mortgage servicing rights, however, since they disappear when the borrower refinances. We saw this in New Residential's earnings: The mortgage company's earnings added $0.82 per share, but mortgage servicing runoff deducted $1.23 per share. As New Residential grows its origination business, the idea would be to get those numbers more in balance.
The market is assigning very little value to the origination business
New Residential makes a pretty solid argument that investors are assigning little value to the mortgage company. While portfolios of mortgage-backed securities generally are valued at book, mortgage operating companies like Rocket and PennyMac Financial Services are not. Mortgage operating companies should be valued based on an earnings multiple. We have seen a number of mortgage companies go public recently at 6 times earnings, and New Residential uses a range of 5X-6X to value the mortgage company. Using the current book value of New Residential at $10.86 per share, and then valuing the mortgage company on earnings, not book, gives you a valuation range of anywhere from $16 to $19 per share -- more than double recent prices.
The obvious template for how to do this would be PennyMac. PennyMac Financial Services houses the mortgage company, which also holds some of the mortgage servicing rights. PennyMac Financial sells much of its production to PennyMac Mortgage Investment Trust, which is a mortgage REIT that holds mortgage-backed securities, some mortgage servicing rights, and credit risk transfer securities.
New Residential is not the only mortgage REIT that trades at a discount to book value; nearly all of them do these days. That said, New Residential is trading at a 27% discount to its GAAP book value, which is huge, due to fears that servicing advances (a short-term cash drain) could rise. AGNC Investment Corp., which invests almost exclusively in government-guaranteed mortgages, trades at a high-single-digit discount. And remember, this is the move New Residential is making, swapping out its legacy book of mortgages that are not guaranteed by the government with loans that are.
New Residential pays a $0.15 quarterly dividend, which works out to a 7.9% dividend yield at Monday's closing price. Using the company's sum-of-the-parts valuation of $16-$19 per share, New Residential is trading at less than half of book value. Investors with a strong stomach to weather the COVID-19-related servicing advances could be rewarded handsomely.