While 2020 was a banner year for the mortgage industry, 2021 is turning out to be a lot more competitive. We have seen profit margins decline as more lenders compete for business. During this time, New Residential Investment (NYSE:NRZ) has been acquiring smaller lenders and building its footprint in the mortgage business. This move will help insulate the company from an impending change in Federal Reserve monetary policy. 

Mortgage REITs are different than most REITs

New Residential has historically been thought of as a mortgage real estate investment trust (REIT). These REITs are a bit different than a typical REIT that develops property. Mortgage REITs invest in real estate debt (in other words, mortgages) and earn interest instead of rent. New Residential also originates mortgages, and it has been building that arm of its business. 

Two hands on a sheet of paper calculating a loan next to a small figurine of a house.

Image source: Getty Images.

New Residential has been beefing up its mortgage origination offerings lately, and recently completed the acquisition of Caliber Home Loans. This acquisition vaults New Residential into the top echelon of non-bank mortgage originators. New Residential hasn't finished its build-out efforts, however; it recently announced it was purchasing Genesis LLC, which originates and services business-purpose loans.

New Residential is interested in professional real estate investors

Genesis focuses on loans to professional real estate developers. Many of these loans fall outside the traditional mortgage financing ecosystem, which is mainly made up of longer-term mortgages that can be guaranteed by the U.S. government. These loans are much shorter term and carry higher rates than the typical Fannie Mae or Freddie Mac mortgage. 

This business helps insulate New Residential from the Fed

For New Residential, these loans are attractive because they carry little interest rate risk. This is simply because shorter-term loans are less sensitive to daily interest rate movements. As a general rule, the longer the loan term, the greater the interest rate risk. This is important because the overwhelming consensus is that the Fed is going to raise rates next year. If you look at the December 2022 Fed funds futures chart, the market thinks there is a better-than-90% chance of a hike next year.

New Residential is bearing credit risk with these loans, which is an attractive risk in this environment. Here's why: Home price appreciation is rising at a high-teens percentage clip. These loans are "money good" given that the value of the property is much, much higher than the amount of the loan. If for some reason the borrower defaults, New Residential will easily cover the loan by foreclosing and selling the property. 

Genesis is expected to originate about $2 billion in loans this year, which is small compared to New Residential's normal origination. That said, with increasing competition in the plain-vanilla mortgage space, the profitability of these loans should be much higher.

New Residential has always been an interesting sum-of-the-parts story. The stock is trading right around its book value per share of $11.27. Since mortgage banks generally trade based on earnings and not book value, you could make an argument that the stock is undervalued. 

That said, mortgage originators are generally out of favor at the moment given the fear of higher interest rates going forward. The key to unlocking value in New Residential might be dependent on a change in investor attitudes toward the sector in general. New Residential has an 8.8% dividend yield, which means investors are being paid pretty well to wait for a revaluation of the sector.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.