2020 was a year to remember for the mortgage originators, and one to forget for the mortgage real estate investment trusts (REITs). For mortgage originators, the COVID-19 pandemic caused the Federal Reserve to push interest rates to the floor, which ushered in a massive refinancing wave. On the other hand, the initial days of the pandemic caused extreme volatility in the mortgage-backed securities market, which triggered a wave of margin calls for the mortgage REITs.
What does the future look like for a hybrid of the two? New Residential (NRZ 1.33%) is a mortgage REIT with an origination arm. The past year was difficult for the company, but it thinks it can recover to pre-COVID levels even as interest rates rise. How is that possible? Read on.
New Residential has 3 different business lines
New Residential is an interesting sum-of-the-parts story with three different businesses. The first business is the investment portfolio, which holds mortgage loans, mortgage-backed securities, and mortgage servicing assets. The second business is mortgage origination, where New Residential is building out its direct-to-consumer origination model. Finally, New Residential performs loan servicing. These businesses will react differently to changes in interest rates, where some will contract, while others will benefit.
For the fourth quarter, New Residential earned $0.16 per share and increased its dividend from $0.15 to $0.20 per share. The mortgage origination business funded $23.9 billion, which was an increase of 125% compared to the fourth quarter of 2019 and an increase of 32% compared to the third quarter of 2020. Gain on sale margins compressed, however, falling from 2.04% to 1.57%. Book value per share was flat compared to the third quarter as mortgage servicing runoff offset earnings in other areas. In terms of market share, New Rez ended the year as a top 15 non-bank mortgage originator and a top 10 non-bank mortgage servicer.
Rising rates will lift book value
Unlike most mortgage originators, New Residential believes that it will benefit from increases in interest rates, which is due to the servicing book. Mortgage servicing rights are unusual assets, in that they are one of the only assets that increase in value as interest rates rise. In fact, New Rez mentioned on the earnings conference call that book value is up 4.4% since the end of the year due to increases in rates. In the earnings presentation, the company forecasts that book value per share will increase by 8.3% (or $0.90 per share) if the 10-year Treasury yield rises to 1.4%. This is due to an increase in the value of the servicing portfolio.
A spin-off or IPO of the mortgage arm might not be in the cards for now
The company is committed to growing organically and returning to some of the more esoteric mortgage lending that it suspended during the early days of COVID. Late last year, New Residential filed a confidential prospectus with the SEC that envisioned doing something with the mortgage origination arm, either spinning it out to shareholders or doing an initial public offering. When asked about that on the earnings call, CEO Michael Nierenberg seemed to indicate that the company may be having second thoughts:
So we are -- without getting too specific, we continue to evaluate what a total separation would mean to the company, meaning NRZ or -- and NewRez. So if we think that it will create more value for shareholders by separating the company and bringing it into the public markets. It's something that's absolutely on the table. As you've seen from some of the recent either attempts or IPOs that have come out with some of our friends and peers on the mortgage company side, some of them have gone OK, others have not gone as well.
As Nierenberg hints at the end, mortgage banking companies are not being rewarded with premium multiples right now. PennyMac Financial is trading at 3 times 2020 earnings per share (EPS), while Rocket trades at 5 times 2020 EPS. In its earnings presentation, New Residential does a sum-of-the-parts analysis and applies a 4-to-6 multiple to the operating company's earnings before interest, taxes, depreciation, and amortization (EBITDA), and it comes up with an implied value of the entire company of anywhere from $14 to $18 per share. The company uses EBITDA in lieu of net income, which is probably due to its structure as a REIT. Most mortgage companies are valued based on net income, not EBITDA.
Regardless of the metric, New Residential's implied book value is well above the current stock price. The company is looking for a way to narrow that discount. In the meantime, today's shareholders are earning an 8.2% dividend yield at Tuesday morning's prices, and are invested in one of the few mortgage companies that stand to benefit from an increase in interest rates. If you believe that we are looking at further stimulus out of Washington, and a big boost in economic growth as more people get vaccinated, then New Residential might be a good way to take advantage of that scenario.