The past year has been miserable for companies in the mortgage industry. Mortgage originators have struggled with declining origination volumes, while mortgage real estate investment trusts (REITs) have contended with mortgage-backed security (MBS) underperformance versus Treasuries.
Redwood Trust (RWT 2.18%) is a mortgage REIT with a hybrid origination and investment strategy, with an extremely high dividend yield. But why is it so high?
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Redwood Trust focuses on mortgages not guaranteed by the U.S. government
Redwood Trust is a housing finance company that is organized as a REIT. The company operates three basic business lines: residential mortgage banking, investment portfolio, and business purpose mortgage banking.
The investment portfolio focuses on a wide variety of nonguaranteed mortgage assets. Business-purpose bridge loans account for the majority of the investment portfolio, at about 33%. Other assets include jumbo loans, reperforming loans (i.e., loans that were delinquent at one point, but now are being repaid), home equity loans, and other assets.
Redwood's origination business concentrates mainly on mortgages that are not guaranteed by the U.S. government. Historically, Redwood Trust has focused on mortgage loans that were too large for a government guarantee. The Federal Housing Finance Agency (FHFA) establishes size limits every year, and it is currently set at $726,200.
If a borrower wants to take out a $1 million mortgage, they will need to get a jumbo loan, which is one of Redwood Trust's main products. Redwood either originates these mortgages or acquires them from a partner and then securitizes them. This is part of Redwood's residential mortgage banking business, which also includes loans ineligible for a government guarantee for reasons other than size.
Redwood's business purpose mortgage banking business focuses on professional real estate investors. The company makes long-term loans for apartment investors, where the loan is underwritten based on expected rental income.
Redwood also specializes in bridge loans, which are meant to be refinanced at a later date. These loans generally last between one and two years, often for renovations, fix-and-flips, and renovate-to-rent.
If everything goes right, the dividend is covered, but barely
Most mortgage REITs have been forced to cut their dividend during the past year. The last couple of holdouts are AGNC Investment (AGNC 0.22%) and Redwood. In the first quarter of 2023, Redwood's book value per share fell slightly to $9.40 from $9.55. Earnings available for distribution came in at $0.11 per share, which is less than half of the $0.23 per share dividend.
That said, Redwood anticipates that future yields on the investment portfolio will be about 17%, which would equate to about $194 million in net interest income. Redwood paid $27.6 million in dividends during the first quarter, which works out to about $110 million per year. Assuming operating expenses are similar to 2022 and management's return forecast proves to be correct, Redwood will be able to cover the dividend, albeit with no margin for error.
Redwood trades at a 36% discount to book value per share. As a general rule, the agency mortgage REITs like AGNC Investment and Annaly Capital (NLY 0.61%) trade at small discounts to book, while nonagency REITs like Redwood or Rithm Capital (RITM 1.24%) have bigger discounts. This is due to the lack of liquidity for nonagency loans and securities.
Data source: YCharts RWT Price to Book Value
The big driver of mortgage REIT returns remains interest rate volatility. Once the Federal Reserve is finished hiking rates, interest rate volatility should decrease, and a big source of uncertainty will be removed from the market. This will be supportive of book value per share.
Investors buying Redwood Trust for that 16% dividend yield need everything to go right for that dividend to survive. That said, if stability in the interest rate market returns, that discount to book value could narrow.
