Over the past 18 months, life has been tough in the mortgage space. Rising interest rates have caused mortgage-backed securities to fall in price, and they have underperformed Treasuries. This has meant falling book values and dividends for the mortgage real estate investment trusts (REITs). Two Harbors (TWO 1.38%) recently cut its dividend, though it still has an attractive yield. Is the dividend sustainable?
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Mortgage REITs are different than the typical REIT
Mortgage REITs are different than the typical REIT. Most REITs invest in real property and then rent out individual units, which is the easy-to-understand landlord/tenant business model. Mortgage REITs don't invest in physical property; they buy property debt -- in other words, mortgages. Instead of collecting rent, they collect interest. In many ways, they look more like banks than landlords.
Two Harbors focuses on agency mortgage-backed securities, which are guaranteed by the U.S. government. If you recently bought a house with a mortgage guaranteed by Fannie Mae or Freddie Mac, chances are it ended up in a mortgage-backed security that might be held by Two Harbors. These securities have no credit risk, but they do have a lot of interest-rate risk.
Mortgage servicing rights are an unusual asset
Two Harbors also focuses on mortgage servicing rights, which are unusual assets. The mortgage servicer will administer the loan on behalf of the mortgage-backed security investor. The servicer is paid a fee of 0.25% for sending out the bills, collecting the payments, and performing other necessary tasks. The right to perform this service is worth money, and it is considered an asset on the balance sheet. Mortgage servicing is one of the few financial assets that increase in value when interest rates rise, so it acts as a natural hedge for Two Harbors' investment portfolio. For most mortgage companies, mortgage servicing rights have supported the business during this period of rising rates.
Two Harbors recently cut its dividend
Two Harbors recently cut the dividend from $0.60 to $0.45 in July. On the earnings call, CEO William Greenberg said the decision was not driven by current or expected earnings. It was a reflection of the investment opportunities in the mortgage-backed securities space, and that should be reflected in the future as higher earnings and book value per share. Importantly, he said the dividend was sustainable while permitting the company to retain flexibility.
If you look at the chart below, the current (post-cut) yield of 13% is more or less around the company's historical range:
TWO Dividend Yield data by YCharts.
Mortgage REITs generally prefer to keep their dividends in a specific range, generally in the low-to-mid teens. Almost every mortgage REIT has cut its dividend in the past year, so Two Harbors' reduction isn't unusual. That said, it has struggled this year, falling 15% year to date.
The big discount to book value is unwarranted
Two Harbors is trading at a 16% discount to book value per share, which is attractive for an agency mortgage REIT. That said, mortgage servicing rights are illiquid and don't have a "market value," as every MSR portfolio is different and needs to be valued individually. Two Harbors is valuing its portfolio at 5.6 times the servicing fee, which is a reasonable valuation, so a large discount to book value seems unwarranted.
At current levels, Two Harbors is reasonably priced, but the wild card remains the Federal Reserve. Once the Fed wraps up its tightening cycle, mortgage-backed securities should, in theory, begin to outperform Treasuries. Mortgage-backed securities have underperformed Treasuries due to heightened interest-rate volatility, which was due to the uncertainty about the Fed's actions. Once that uncertainty goes away, MBS pricing relative to Treasuries should improve.
It is hard to like the mortgage REIT sector while the Fed is still in tightening mode. Once they indicate that the tightening cycle is over, the mortgage REIT sector should become investable. That said, the dividend is probably safe for now.
