The past year has been downright awful for companies in the mortgage space. The majority of the blame lies with rising interest rates. Mortgage originators saw volumes collapse as rising rates removed the incentive for borrowers to refinance their homes. It also caused mortgage-backed securities to get sold off as bond fund managers sell their most liquid securities to meet redemption obligations.
This caused mortgages to underperform Treasuries and mortgage real estate investment trust (mREIT) stocks to underperform the stock market. This pushed dividend yields up to the point where these stocks become outliers. So why is Redwood Trust's (RWT 0.18%) dividend yield so high?
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Mortgage REITs are different than the typical REIT
Mortgage REITs have a different business model than most REITs. The typical REIT develops properties such as office buildings, shopping malls, or apartment buildings and then rents out the individual units. Mortgage REITs don't invest in real estate, they invest in real estate debt and their business model is more similar to a bank or hedge fund in that they collect interest instead of rent.
Redwood Trust is somewhat different than the typical mortgage REIT in that it has an operating loan origination business. Redwood Trust is a correspondent originator (meaning it largely buys completed loans from smaller lenders) and it focuses primarily on jumbo loans, which are too large to be guaranteed by the U.S. government, and non-qualified mortgage loans, which are ineligible for a government guarantee. Redwood also has a business purpose lending arm, which makes loans to real estate developers for multifamily rentals and bridge loans. Finally, Redwood has a portfolio of loans it originated that it holds for investment purposes.
NYSE: RWT
Key Data Points
Originators in Redwood's space have filed for bankruptcy this year
Redwood Trust has struggled this year as the securitization markets saw spotty liquidity. Some originators in Redwood's sandbox filed for Chapter 11 bankruptcy protection this year (First Guaranty Bank) or effectively shut down (Sprout Mortgage). Trader concerns that Redwood Trust might do so as well have weighed on the stock and it underperformed the safer agency REITs like AGNC Investment and Annaly Capital.
In the third quarter of 2023, Redwood reported a loss of $0.44 per share under generally accepted accounting principles (GAAP), which was driven primarily by mark-to-market losses on its investment portfolio. These mark-to-market losses were unrealized, which means if the market bounces back, so should Redwood's book value per share. Earnings available for distribution came in at $0.16 per share, which didn't cover the $0.23 per-share dividend.
A housing recession will mean problems for Redwood
Redwood Trust's earnings going forward will be a function of the housing market and the mortgage-backed securities market. There has been a lot of talk in the business press about the U.S. entering a housing recession. Homebuilding is in decline, mortgage banking is moribund, and affordability has fallen. All these things will negatively affect Redwood's business lines.
Ultimately most of Redwood's loans are not issued to individual homeowners; they are to real estate investors. Rising rates will eat into the expected cash flows of these real estate investors, which will make default more of a risk if rents don't rise as expected. In addition, hedging these loans against interest rate risk is much harder than a typical mortgage. This makes the portfolio harder to manage.
Redwood has a lower dividend yield than most of the mortgage REIT space at 12.4%. The company does have a more diversified income stream than most mortgage REITs, however, the entire mortgage space is suffering including mortgage-backed security investors and originators. The risk that this will continue well into 2023 is the main reason why Redwood's dividend yield is so high.
