The year 2020 has been difficult for mortgage real estate investment trusts (REITs). The early days of the crisis caused the U.S. bond market to react violently as the market realized how dramatically the pandemic would hit economic growth. This caused every mortgage REIT to shrink its balance sheet and cut dividends. Many companies in the sector had what could only be called a near-death experience.
The drop in interest rates sparked by the downturn in the U.S. economy, however, gave birth to a home refinancing wave that has given the mortgage sector its best year since the early 2000s.
New Residential Investment (NRZ +1.02%) is a mortgage REIT with an origination arm, which gives it an operating company that generates cash to accompany the earnings from mortgage investment.
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COVID-19 forces a business model change
Prior to the COVID-19 crisis, New Residential focused primarily on originating mortgages that didn't qualify for purchase from Fannie Mae or Freddie Mac. These are referred to as nonqualified mortgages (non-QMs), and they represented a growing but still small part of the mortgage market.
These are loans typically made to borrowers who are self-employed, which means the income on their tax return doesn't capture their true earnings. This is especially true for real estate investors, who tend to have a lot of depreciation and amortization.
The COVID-19 crisis depressed liquidity in the mortgage market, and New Residential found itself holding loans it was unable to sell. The company made a strategic decision to exit the non-QM business to focus solely on loans that are salable to Fannie Mae and Freddie Mac.
A balanced business model
New Residential's business is basically broken down into origination, servicing, and investing. The investing portion is like the typical mortgage REIT, which holds loans or securities and earns money from a spread between the interest it earns and its cost of financing.
The servicing business involves managing the administrative tasks of a mortgage, including collecting payments, dealing with defaults, and ensuring taxes are paid.
The origination business is a direct-to-consumer model where borrowers interact with New Residential directly to obtain a mortgage. These different businesses will perform well during different phases of the interest rate cycle.
Mortgage banking IPOs are hot
New Residential just filed a confidential prospectus with the Securities and Exchange Commission to conduct an initial public offering (IPO) for its origination business. We have seen a number of mortgage banking IPOs this year, and other originators have filed to go public (although some have been temporarily delayed), including AmeriHome, Caliber Home Loans, and LoanDepot. The mortgage banking business is highly cyclical, and the industry is striking while the iron is hot. New Residential is betting that by spinning off its mortgage banking business, the market will value the lending arm on an earnings multiple and not book value.
Origination will probably provide most of New Residential's revenue. Last quarter, origination contributed about two-thirds of the company's $685 million in revenue. As long as interest rates stay low, mortgage origination should feast. Mortgage servicing rights have been under pressure since the early days of the coronavirus as investors have worried about delinquencies and refinancings. As the COVID crisis winds down, servicing values should rebound. Mortgage servicing is one of the few assets that go up in value as interest rates rise.
Lastly, the mortgage-backed securities portfolio is concentrated in mortgages that are guaranteed by the U.S. government. These securities will be less sensitive to a further increase in delinquencies.
New Residential's diversified business model makes it a bit more resilient than the typical mortgage banker or mortgage REIT. This makes the dividend safer as well. The company cut its dividend in April from $0.50 per share to $0.05, but it increased the per-share dividend to $0.10 in July, to $0.15 in October, and is planning a $0.20 per share dividend at the end of December. The December dispersal would put New Residential's yield at 8%, which is much higher than the typical mortgage originator, and relatively on par with the typical mortgage REIT. The catalyst of an origination spinoff or IPO is another way investors can win with this stock.
