This year has been extraordinarily difficult for companies in the mortgage business. Mortgage originators saw a collapse in volume as rising rates made refinancing unattractive for homeowners. Mortgage real estate investment trusts (REITs) were beset by a combination of rising rates and mortgage-backed security underperformance. As a result, many of these companies now have quite high dividend yields.
Rithm Capital (RITM 1.28%) is a combination mortgage originator and mortgage REIT and its dividend yield now hovers around 11%. Is that dividend sustainable?
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Rithm has a diversified business model
Rithm Capital is a REIT with three different business lines. This revenue diversity insulates it somewhat from the volatility of the mortgage business. Rithm holds mortgages for investment, originates mortgages, and is in the mortgage servicing business. Mortgage servicing has been the most solid segment for the company this year.
Mortgage servicing is an unusual asset
Mortgage servicers perform the administrative tasks of handling a mortgage on behalf of the ultimate holder of the loan. The servicer collects the monthly payment, forwards the principal and interest payments to the investor, ensures that property taxes and insurance are paid, and works with the borrower in the event of a default. For compensation, the servicer gets paid 0.25% (a quarter of 1 percent) of the loan amount. So on a $400,000 mortgage, for example, the servicer gets paid about $1,000.
The right to perform that duty is worth something, and that right is capitalized on Rithm's balance sheet as an asset. During a period of rising interest rates, the incentive to refinance generally disappears. This means that the servicer will earn that fee for longer, which makes the servicing asset increase in value. Mortgage servicing is one of the few assets that actually increases in value as interest rates rise.
The mortgage servicing asset also represents a robust source of steady cash flows, which helps offset some of the feast-or-famine aspects of the mortgage business. During the third quarter of 2022, mortgage servicing accounted for about half of Rithm Capital's revenue. Interest and mortgage origination revenues accounted for the balance.
The Federal Reserve may become less of a headwind
The mortgage business struggled this year as the Federal Reserve has been hiking the Fed funds rate in an effort to bring down inflation. The Fed has acted aggressively, and Fed Chair Jerome Powell recently hinted that it was time to start slowing the pace of rate hikes. This will help reduce volatility in interest rates, which will be helpful both for holders of mortgage debt and for mortgage originators. Mortgage REITs suffered from widening mortgage-backed security spreads, which also pushed up borrowing rates.
Rithm Capital pays a quarterly dividend of $0.25 per share. Last quarter, the company earned $0.26 per share, so the dividend was covered in what was one of the worst quarters for mortgage originators in years. As mortgage-backed security spreads revert to normal levels, this will bolster earnings on the mortgage-backed security portfolio and should also help the origination business, at least somewhat. The mortgage business is probably looking at a difficult 2023 as well, but the worst is probably over. The current dividend payout rate and its 11% dividend yield are not a lock, but the dividend looks relatively stable absent some shock to the mortgage or financial market.
