Two Harbors Investment Corp. (TWO 2.30%) continues to make an attractive value proposition for investors looking for both recurring dividend income and capital gains: The hybrid mortgage REIT trades at a 9% discount to its accounting book value and has a lower risk profile than its peers.
However, the lower balance-sheet risk of Two Harbors Investment doesn't come at the expense of an inferior dividend yield. In fact, its 11% dividend yield is quite competitive and makes Two Harbors Investment an attractive choice for cash flow-minded investors.
Business model
Two Harbors Investment is a mortgage REIT that invests in agency residential mortgage-backed securities. The principal and interest payments from the underlying mortgages of such securities are guaranteed by government-sponsored enterprise Fannie Mae, Freddie Mac, or Ginnie Mae (though Ginnie Mae is not a GSE).
Two Harbors Investment is a mortgage REIT that invests in agency residential mortgage-backed securities. The principal and interest payments from the underlying mortgages of such securities are guaranteed by government-sponsored enterprise Fannie Mae, Freddie Mac, or Ginnie Mae (though Ginnie Mae is not a GSE).
Source: Two Harbors Investment Second Quarter Earnings Presentation
Its investment portfolio at the end of the second quarter consisted of $14.5 billion in assets, of which 46% related to 30-year fixed-rate mortgages.
1. Net asset value discount points toward potential capital gains
When it comes to judging the attractiveness of a mortgage REIT, investors need to look beyond the dividend yield.
There are a variety of indicators that suggest whether a REIT is an attractive investment candidate: A low net asset valuation, its historic performance, or its dividend trend can give investors vital clues about the value proposition of a proposed income investment.
Two Harbors Investment currently trades at a 9% discount from its accounting book value, which is lower than the 12% discount for American Capital Agency Corporation (AGNC 1.60%), and the 14% discount from Annaly Capital Management (NLY 2.13%).
In any case, the discount to Two Harbors Investment's net asset value suggests that investors could see capital gains down the road, which would come in addition to a respectable dividend stream. This is particularly true for Two Harbors Investment, whose shares usually trade higher than the current valuation (see chart below).
2. An end to dividend cuts?
It was a difficult 2013 for mortgage REITs, as the sector experienced a great deal of trouble because of the Federal Reserve's uncertain monetary policy.
It was a difficult 2013 for mortgage REITs, as the sector experienced a great deal of trouble because of the Federal Reserve's uncertain monetary policy.
As a result, the profitability, book values, and dividends of mortgage REITs all went south in 2013. And investors only want to know one thing: Has the storm passed, and does a purchase of a mortgage REIT now make sense?
The dividend trend can give a clear answer here: Although Two Harbors Investment's dividend per share has contracted substantially from $0.40 in Q3 2011 to $0.26 in Q3 2014, for a hurtful 35% decline, dividends appear to have stabilized now at $0.26, a payment level that Two Harbors Investment has held steady at for four consecutive quarters. We've also seen this theme play out for larger players Annaly and American Capital Agency.
3. Appealing leverage profile
Leverage is a big thing for mortgage REITs and naturally an area of interest for investors.
Leverage is a big thing for mortgage REITs and naturally an area of interest for investors.
Mortgage REITs basically take on large amounts debt to fund their operations and are subject to a "maturity mismatch." This mismatch happens because mortgage REITs take on short-term debt and invest those funds in long-term mortgage securities, and it can cause significant trouble for a company if credit markets freeze up.
Source: Two Harbors Investment second-quarter earnings presentation.
Generally speaking, a mortgage REIT with lower levels of leverage and prepayment risk is perceived as more desirable, assuming its dividend its competitive.
From a leverage point of view, Two Harbors is significantly lower levered than its mortgage REIT peers, including Annaly and American Capital Agency: While the mortgage REIT peer group has an average leverage ratio of 6.4 in 2014, Two Harbors Investment exhibits a leverage ratio of only 2.9.
Two Harbors Investment has also aggressively de-levered its balance sheet since 2011, as seen in the falling leverage ratio over time, and benefits from significantly lower levels of prepayment risk than its peers.
Two Harbors Investment is an attractive mortgage REIT for a variety of reasons. Its low book valuation suggests investors could benefit from capital gains in addition to its juicy 11% dividend yield. In addition, the mortgage REIT compares very favorably in terms of leverage and prepayment risk, which is something cash flow-minded investors like to see as well.
