The past 18 months have been miserable for companies in the mortgage business. Mortgage originators have seen origination volumes collapse as the Federal Reserve began its policy of raising interest rates to defeat inflation. Mortgage real estate investment trusts (REITs) have seen their assets decline in value. Most mortgage REITs were forced to cut their dividends. Redwood Trust (RWT 0.88%) also cut its dividend. Is the new dividend sustainable?
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Mortgage REITs are different than typical REITs
Mortgage REITs are different than the typical REIT that focuses on property management. The typical REIT develops commercial real estate and then rents out the property to a tenant. It is the classic, easy-to-understand landlord/tenant business model. Mortgage REITs don't invest in property for the most part; they invest in property debt, which generally means mortgages. Instead of collecting rent, they earn interest. In many ways, a mortgage REIT looks more like a bank or hedge fund than a typical REIT.
Redwood Trust is a mortgage REIT that focuses on three strategies: Residential mortgage lending, business purpose mortgage lending, and mortgage investment. Unlike most mortgage REITs, Redwood Trust focuses on mortgages that are not guaranteed by the U.S. Government. This separates Redwood from mortgage REITs like AGNC Investment (AGNC 0.97%), which focuses on government-guaranteed mortgage-backed securities. The difference is that AGNC Investment generally does not bear credit risk, while Redwood Trust does. In other words, if the borrower defaults on the mortgage, AGNC Investment still gets everything it is owed. Redwood Trust does not.
Redwood Trust has a different business model than agency mortgage REITs
The residential mortgage lending segment focuses on jumbo loans and non-qualified mortgage (QM) loans. Jumbo loans are mortgages that are too large to be guaranteed by the government. If you are buying a mansion with a mortgage, you are probably getting a jumbo mortgage. Non-QMs are loans for borrowers who don't meet the criteria to get a mortgage from the government or the government-sponsored entities Fannie Mae and Freddie Mac.
These loans look nothing like the subprime loans from the bad old days; they are generally made to professional real estate investors who intend to use rental income to cover the mortgage. These loans often carry high interest rates, require the borrower to put up a substantial down payment, and require the borrower to have six to 12 months of reserves.
Potential changes to bank regulation provide an opportunity for Redwood
Jumbo mortgages present a big opportunity for Redwood Trust going forward. U.S. banking regulators have proposed to increase the capital requirements for banks with over $100 billion in assets. This rule will make jumbo loans less profitable for banks. Redwood sees an opportunity to partner with banks that want to originate jumbo mortgages and then sell them to Redwood, which isn't subject to these capital charges.
On the earnings conference call, Redwood CEO Chris Abate characterized the impending change as a "very positive market shifting event" for Redwood's business.
Redwood Trust recently cut its quarterly dividend from $0.23 to $0.16 to better align with the company's near- to medium-term outlook and allow Redwood to take advantage of opportunities. In the second quarter of 2023, earnings available for distribution came in at $0.14, which is below Redwood's $0.16 dividend. Redwood anticipates the mortgage market picking up in the second half of 2023, which should make the dividend supportable.
Redwood Trust is expected to earn $0.87 per share in 2024, which more than amply covers the $0.64 annual dividend. The mortgage REIT sector has struggled over the past 18 months as the Federal Reserve hiked interest rates. Redwood Trust is trading at a 14% discount to book value per share, which is attractive compared to historical numbers. Redwood's stock price has reacted positively to the rumored changes, outperforming agency REITs like Annaly Capital (NLY 1.02%) and AGNC Investment. Redwood Trust has a unique niche in the mortgage REIT market and is poised to benefit from a potential regulatory change.
