It All Starts With Demand For Housing
The market for home ownership has improved dramatically from the dark days of the 2007 financial crisis. The economy is in one of the longest periods of expansion in history, the housing sector has been on fire, home ownership is well ahead of 2009 lows, and until recently mortgage interest rates were at rock bottom. Even with all this momentum the outlook for demand remains strong. That’s good news for New Residential Investment Corp; here is why.
To begin, the notion of home ownership remains a dream for over one-third of American families. Since 2006 the percent of home ownership has fallen to near the lowest level in 20 years. A recovery to 2006 levels alone would create demand for millions of additional homes.
Where this most likely to take place is in the closely watched Millennial segment of 18-34 year olds. This group amounts to nearly 100 million. Only 35% are homeowners at present as most members of this group are renters either by choice or while establishing sufficient credit. But for all the negative news about overwhelming student loan debt, homeownership of this group is the fastest growing.
Millennials are now producing the next baby boom. This is turning apartment renters into families seeking home ownership. Rapidly rising incomes are also playing a role. The average income for an 18-34 year old family of two is over $70,000 with most new high paying jobs being created in technology, a hotspot for this group. As they table below shows, mortgages for those that still lack pristine credit is doing well. Over the last year, we’re talking about over $55 billion in just the so called “private-label RMBS” (more about that in a minute) market.
A Look Under The Hood
New Residential Investment Corp. is a leading real estate investment trust (REIT). They are not just another typical REIT. They are a mortgage REIT. They don’t own apartments, shopping malls or hotels. Instead, they invest in real estate securities such as mortgages and then hedge those investments with other interest rate sensitive securities. Wall Street wiz Michael Nierenberg founded the company back in 2013 and today; New Residential is one of the top mortgage REITs in the US.
As the name implies, the sole purpose of New Residential Investment Corp. is to invest in residential mortgages and related securities. This separates NRZ from other mortgage REIT such as Annaly Capital Management, Inc. that participates in both the residential and more risk oriented commercial markets.
New Residential Investment Corp uses equity capital along with borrowed funds in an effort to earn the spread between the yield on invested assets and the cost of borrowed funds. The objective is to generate net income for distribution to stockholders through the prudent selection and management of these investments.
FYI: Tax Exempt
What makes REITs interesting and residential mortgage focused REITs every bit as much? REITs are exempt for federal taxes so long as at least 90% of taxable income is paid out to shareholders. Accordingly, the yield on REITs is typically far more attractive than alternatives such as bonds, preferred or high yielding common stocks.
In addition to favorable tax treatment and superior dividend yields, REITs specializing on residential mortgages have been one of the brightest spots of the 859 companies that comprise the stock markets financial sector. So along with superior dividend yield comes capital appreciation as well.
The New Residential Strategy Is Tightly Focused
According to the website Barchart, New Residential ranks 50th based on NRZ market capitalization of $6 billion. Reaching these heights is no small accomplishment considering the modest five plus years of operating history.
In reality New Residential does not compete with most of the giant REITs like American Tower ($61.8 billion market cap), Simon Property Group ($51.7 billion), Crown Castle International — ($42.5 billion), or Public Storage ($38.0 billion) Each of these has been around for decades and tend to invest directly in one or more functions including location, development construction and management of real estate including residential, commercial and industrial.
New Residentials strategy is far more tightly focused exclusively on residential mortgages and associated services. In this way NRZ is more comparable to $13 billion Annaly Capital. However, ALY invests in both residential as well as commercial mortgages and thus making NRZ rather unique based on its size and business focus.
One of the risks the NRZ strategy largely mitigates is the liquidity trap that often cripples traditional REITs during slowing economic periods. Notwithstanding the one time shock of 2007 the $10.3 trillion US mortgage market affords New Residential with instant liquidity.
Another distinguishing feature of New Residential is their low cost structure that hasn’t sacrificed access to some of Wall Street’s brightest and most successful investment managers. This is possible because NRZ contracts the execution of its strategy to investment industry giant Fortress Investment Group.
Executing The Strategy
Unless you are in the mortgage business, you may be scratching your head right now looking for an english language version of what New Residential is all about. So let’s make that happen.
Activities are organized into four functional areas:
- Excess MSRs
- Service Advances
- RMBS and Associated Call Rights
- Other Investments
Excess MSRs (48% of Portfolio)
A mortgage servicing right (“MSR”) provides a mortgage servicer with the right to service a pool of mortgage loans in exchange for a fee. An MSR is made up of two components: a basic fee and an Excess MSR. The basic fee is the amount of compensation for the performance of servicing duties, and the Excess MSR is the amount that exceeds the basic fee.
As the owner of an Excess MSR, New Residential collects monthly cash flows from the MSR, but does not assume any servicing duties, advance obligations or liabilities associated with the portfolios underlying their investment. New Residential has been a pioneer in MSRs due to their attractive risk/reward characteristics.
RMBS and Associated Call Rights (29% of portfolio)
RMBS stands for Residential Mortgage Backed Securities. RMBS can be identified as either Agency or Non Agency. Both types are created through the securitization of a pool of residential mortgage loans. At any given time about 70% of all US residential mortgages are securitized.
That amounts to over $7 trillion in securitized mortgages of which the vast majority are highly liquid. There is one important difference between the two types. Agency mortgages are typically backed by one or more Federal organizations such as Ginnie Mae, Fannie Mae or Freddie Mac. Most are backed by the full faith and credit of the United States government so there is almost no risk of default. Returns on these securities reflect this condition.
On the other side of the spectrum are “non-agency” MBS, sometimes called “private label” securities. The very same banks and other financial institutions, that issue agency mortgage-backed securities offer non-agency mortgages as well. These, however, are not guaranteed so there is default risk reflected in the pricing.
To be successful, the investor must able to gage default risk compared with other RMBS offering similar yields and make the right investment choices. This is where New Residential comes in.
The most unique aspect of mortgage-backed securities is the element of prepayment risk. This is the risk that investors decide to pay back the principal on their mortgages ahead of schedule. The result, for investors in MBS, is an early return of principal. In this scenario, the owner of the MBS is forced to reinvest the returned principal at lower rates.
Prepayment risk is typically highest when interest rates are falling, since this leads homeowners to refinance their mortgages. This means that the principal value of the underlying security shrinks over time, which in turn leads to a reduction in interest income. This is where Call Rights can both protect against risk as well as providing a means to potentially enhance returns.
The owner of the call rights can purchase loans from the pool at par plus expenses and make a profit by selling or re-securitizing performing loans at a premium while retaining distressed loans to modify or liquidate. This is where New Residential stands out.
New Residential recognizes a profit when the aggregate loan value is greater than par on all the loans (minus any discount from acquired bonds) plus expenses related to such exercise. In other words NRZ takes a bundle of non-Agency mortgages, selectively retains loans that meet return thresholds or re-securitizing or selling performing loans for a gain. Just prior to exercise, purchasing certain underlying tranches at a discount to par. Upon exercise, they are able to realize any remaining accretion to par.
Aftermath Of The Financial Crisis
The financial crisis in 2007, produced significant volatility in the prices for non-Agency RMBS. This immediately resulted in a widespread contraction in capital available for this asset class, deteriorating housing fundamentals, and an increase in forced selling by institutional investors (often in response to rating agency downgrades).
A large component of NRZ’s residential strategy has been driven by shift of U.S. mortgage servicing. Some 83% of the nearly $10 trillion servicing market is dominated by banks (the top four control 48%). In the aftermath of the financial crisis banks have been under significant pressure to reduce servicing exposure due to: heightened capital requirements, regulatory and headline risk and elevated troubled loan levels.
While the prices of these assets have recovered substantially from their lows, there are still opportunities to acquire non-Agency RMBS at attractive and above average risk-adjusted yields.
Banks Continue To Improve Capital Ratios
The financial health in the banking sector has improved markedly from the financial crisis. As this takes place their ability to write off and sell non-performing loans has improved. For these institutions, cleaning up their balance sheets is more important than selling at the highest and best price. While the so called low hanging fruit may have been picked there is still opportunity for New Residential.
An increasing number of sales are taking place by the HUD who had been forced to acquire non-performing loans from Ginnie Mae. In addition sales of defaulted loans are increasingly taking place from traditional residential loan servicing companies
Doing Thorough Research
New Residential’s expertise lies in their ability to find an abundant supply of non-Agency RMBS vehicles where a discrepancy exists between the price of the non-Agency RMBS and the recovery value of the underlying collateral.
Service Advances (3% of Portfolio)
Service advances are reimbursable cash payments made by a servicer either of two events take place. First when the borrower fails to make scheduled payments due on a mortgage loan. Secondly to support the value of the collateral property.
The purpose of the advances is to provide liquidity to the underlying residential mortgage securitization transaction. These payments are not credit enhancements and Servicer Advances are usually repaid from amounts received with respect to the related mortgage loan.
Advances are very high credit-quality because they are first in line to be repaid and thus below average risk. Service advances provide an opportunity to invest in core servicing assets that generate attractive yields.
Other Investments (19% of Portfolio)
This part of NRZ portfolio can be subdivided into three components: residential, commercial and cash. While not a mainstream part of New Residential there are pockets of opportunity to invest in portfolios of non-performing and other residential mortgage loans, including performing, re-performing and reverse mortgage loans. As the economy has continued its recovery, these types of opportunities have become more attractive.
Financial Performance Has Been Superior
Since coming into public existence in May 2013 New Residential has provided investors with a continuous stream of quarterly dividends starting at just $18 million over $505 million during the first nine months of the current year: a total of more than $2 billion.
Recently the highly respected analyst at Seeking Alpha commented about why bullish investors admire New Residential:
“Over the past several years, New Residential has grown book value consistently at the same time the book value of most mREIT peers has declined. Dividend coverage has been maintained based on core earnings (even backing out incentive fees to the manager) over this period and returns on equity have been higher than well, pretty much everyone. Probably less understood by the market are the positives coming out of the Shellpoint acquisition – at least from management’s view on how they want to run this business. Beyond the $69B servicing portfolio and the associated servicing business acquired through Shellpoint, New Residential also acquired a decent loan originator that will create billions in retained servicing rights from loans it originates and sells, helping offset portfolio run-off. Shellpoint does underwrite non-agency loans (feeding its assets there), but it also picked up a Ginnie Mae license which gives it another avenue for acquisitions of MSRs in the agency space. Only in the past several years has New Residential been able to fully own MSRs – in the past it was only able to own “excess MSRs”, a product type it helped bring to the mainstream.”
As for Zacks Investment Service:
“For those looking to find strong Finance stocks, it is prudent to search for companies in the group that are outperforming their peers. New Residential Investment is a stock that can certainly grab the attention of many investors.”
What Is New Residential Worth
Over the past year Wall Street expectations for New Residential have moderated and this change may afford opportunity for investors seeking above average returns in the financial sector. At recent prices around $16 NRZ is selling around the midpoint of its 12 month range of $13.86-$18.75. The consensus of Wall Street analysts for this year is $19.31 or about 20% above current levels. Should this forecast prove accurate, NRZ is likely to perform better than the benchmark S&P 500.
The very same group of analysts projects forward 12 month earnings of $2.00 which means the price earnings ratio is a meager 4.25 while the yield on the $2.00 annual dividend is at the irresistible level of over 12.25%.
Between the upside potential of 20% and the current yield of 12.25% appears to be uncommonly generous value. Logic alone insists that investors are cautious (however, short interest is just a little under 5%) or that NRZ earnings are not likely to continue their upward momentum.
For the first nine months of 2018, net income of $963, 619 ($2.64 per share) surpassed full year 2017 results of $957,333 ($2.62 per share). This suggests that consensus estimate for full 2018 of $2.35 per share is clearly on the side of ultra conservative. Perhaps the same can be said for 2019 estimates that average just $2.27 per share. The next financial report for full year 2018 is due in February.
Learn more about Michael Nierenberg and New Residential Investment, here.