The past year has been exceedingly difficult for companies in the mortgage industry. Mortgage originators have seen a collapse in volume as rising interest rates and home prices have made housing much less affordable. Mortgage real estate investment trusts (REITs) have suffered as the Federal Reserve's aggressive tightening policy has increased volatility in the bond market, which has caused mortgage-backed securities to underperform Treasury securities.
One company, a hybrid mortgage REIT and mortgage originator, has managed to outperform its mortgage REIT and mortgage origination peers. Its name is Rithm Capital (RITM 0.38%). What is its secret?
Rithm Capital: A diversified mortgage REIT
Rithm Capital is a diversified mortgage REIT that focuses on mortgage servicing, mortgage origination, and investing in mortgage-backed securities. It has a portfolio of companies that provide ancillary services to the mortgage industry. The company built this portfolio to outperform in any interest rate environment. So, if mortgage origination is suffering, another business will pick up the slack. As rates have risen this year, mortgage servicing has done the heavy lifting for profitability.
Mortgage servicing is a unique asset
Mortgage servicing is a highly unusual asset, and one of the few that benefits from rising interest rates. Mortgage servicers perform the administrative tasks of managing the loan on behalf of the investor. They collect payments from the borrower, send the principal and interest payments to the investor, ensure property taxes and insurance are paid, and deal with borrowers if they get in trouble and start missing payments.
The servicer is generally compensated 0.25% of the mortgage's balance outstanding each year. So if the mortgage's balance is $400,000, the servicer gets paid $1,000. The right to perform this duty is worth something, and mortgage servicers will buy and sell these rights.
Servicing revenue made up about half of Rithm's revenue last quarter
Rithm's mortgage servicing portfolio has a face value of about $615 billion. It also performs subservicing duties on behalf of other lenders, for which it earns a fee as well. Servicing income accounted for almost half of Rithm's revenue in the third quarter of 2022. Earnings per share rebounded from a loss of a penny a share in the second quarter to $0.26 per share.
Year to date, Rithm stock is down about 20%. However, this is a much better performance than mortgage REITs such as AGNC Investment (AGNC 1.19%) and Annaly Capital (NLY 0.89%). It's also much better than the big mortgage originators like Rocket (RKT 0.80%) and UWM Holdings (UWMC -0.52%). While most of these companies do hold some mortgage servicing, it isn't as big a component as it is for Rithm.
The big question for Rithm concerns life after the Fed wraps up its steady diet of rate hikes. If the U.S. enters a recession, then servicing costs will increase as more borrowers get into financial trouble. During recessions, interest rates tend to fall, which would reduce the value of Rithm's servicing portfolio -- although it would certainly help the mortgage origination business. Rithm has shown that its model outperforms in a rising rate environment, although that might change when rates stabilize.
At current levels, Rithm is trading at 6.3 times expected 2023 earnings per share. At first glance, that might look like a super-attractive multiple. Unfortunately, mortgage companies have such volatile earnings streams that they never really get a premium multiple. During good times, they might trade at price-to-earnings (P/E) ratios below 5. Rithm does pay a decent dividend of $0.25 a quarter, which gives the stock a dividend yield of almost 12%.