Taking Advantage of the REIT Sell-off
For some time now I have wanted to take advantage of companies that will benefit from improving credit conditions. Yet since the beginning of the year the steep run-up in these stocks has led me to limit my purchases to a small position in Arbor Realty (ABR) and a short lived position in RAIT Financial (RAS).
Thus I am pleased that we are finally seeing a significant correction in these names. The correction is being brought about by the rise in interest rates, a pullback in the credit markets (here and here), my interpretation of which is that it has been driven by a temporary oversupply and of course fears of the Fed, and investors inability to distinguish between more unconventional REIT structures that are not sensitive to increases in interest rates and simple agency and non-agency mortgage REITs that are. The companies that I am interested in are mostly agnostic to interest rate increases and in some cases will actually benefit from a rise in rates, but that hasn’t stopped them from selling off.
In the last three weeks I have taken advantage of the sell-off by buying shares in the following names:
- New Residential (NRZ)
- PennyMac Mortgage (PMT)
- Northstar Realty (NRF)
The first company on the list is not a new one. I have owned Newcastle Investments, from which New Residential was spun-of in the middle of May, for about a year and a half now. New Residential got hit very hard by the REIT sell-off, falling from a high of above $7 to just a few cents over $6. Unfortunately this was a situation where $6.75 looked good to me, $6.50 looked better and $6.25 even better, so I was buying all the way down and, rather than catching the bottom, I caught a falling knife, and ended up with an average a cost of around $6.55.
There is a pretty good summary of New Residential’s assets in this article. Below I have snipped a slide from the company that summarizes their assets and net investments in each area.
About half of the net investments are mortgage servicing rights (MSRs). It’s hard to believe I’ve been talking about MSR’s for almost a year and a half now and still feel there is opportunity, but I do. As I’ve said multiple times, the MSR’s being written today are some of the highest quality servicing rights ever. The loans are being originated at an interest rate trough where the risk of refinancing is low, with extremely strict underwriting criteria so the risk of default is low, and at a time when house prices have passed their trough and are beginning the up-swing. I think we are all going to be surprised by just how long these loans (and necessarily their corresponding MSRs) stay on the books.
The rest of the assets are comprised of commercial loans and non-agency RMBS, which are going to be more sensitive to improvements in the economy (which will improve the condition of the underlying collateral which has been bought at a discount to par) than the rise in interest rates. While the company does have a relatively large balance sheet position in agency CMBS, it makes up only a small amount of the company’s equity because of the leverage involved.
Since mortgage servicing assets make up such a big portion of the company’s investments and since they are the primary reason I have taken such a large position in New Residential, I want to talk a bit more about the company’s mortgage servicing portfolio. The 7th slide of the company’s May Presentation provides details.
The key metrics to focus on are the CPR, which is the prepayment rate and the recapture rate. Between the two of these you can get a sense of how long mortgage servicing assets are staying on the books and how good the company (through their servicing partner Nationstar) is at recapturing those loans when they are prepaid.
What I think is particularly noteworthy about the table is the recapture rate. I remember reading Nationstar’s prospectus last year (Nationstar is, of course, the partner of New Residential and manages the actual servicing of the mortgages involved), that their projection was for a 35% recapture rate, and that they suggested that if everything went right they may be able to push that level up to 50%. Its impressive that they have met and, in the case of the second pool, exceeded that rate.
Unlike other mortgage assets, the value of mortgage servicing rights increases as interest rates rise because the probability that the loan refinances diminishes. The longer that the mortgage servicing right stays on the books, the longer that New Residential will collect the fee income. Given that we’ve had years and years of lower interest rates, I think there is a reasonable chance that there is an upside surprise to just how long existing mortgage servicing rights generate fees. Even though the mortgage servicing right asset has received much more attention over the last year than when I first began investing in them, I think that investors are still underestimating their longevity.
With New Residential trading down 15% from its peak, and at a level that offers about a 10% dividend, I believe the sell-off offered an excellent opportunity to add to my position in the stock. So I did. Its now the largest position in my portfolio.
I owe this idea to Bigenergybull, an investorsvillage poster who I was told will soon be changing his name to BigREITbull, which doesn’t have quite the same ring to it.
PennyMac Mortgage (PMT) operates three different businesses: they buy distressed real estate loans and MBS, they originate correspondent loans, and they hold on to the mortgage servicing rights that they receive from the loans that they originate.
Two of these businesses (mortgage servicing rights and the distressed real estate) will benefit from an improving economy, while mortgage servicing rights will also benefit directly from rising rates. And while one might think that the correspondent business would be hurt by lower volumes, a more nuanced view of the business suggests that the impact might be mitigated: lower volumes and margins on small banks and brokers will force them to sell more of their mortgage servicing rights in order to cover the cash flow requirements of the origination business. While the total number of loans being originated will decline, the share of loans through the correspondent segment should increase. I also looks at PennyMac’s correspondent business as more of a platform to accumulate assets than a stand-alone profit center. In addition to the mortgage servicing rights that the company takes in through the business, they have been expanding their lending to jumbo loans, which I expect they will begin to securitize privately (keeping an equity stake) once the market allows.
The mortgage servicing portfolio at PennyMac is only about 10% of assets. Its not nearly the size of the New Residential operation, and future growth will depend on loans originated from the correspondent business. Admittedly the company capitalizes their servicing rights rather aggressively at 100 basis points, while most competitors I’ve seen are closer to the 75 basis point range. So they are booking a good chunk of the potential upside I see in servicing up front.
The larger opportunity at PennyMac comes from the distressed loan business. Distressed loans and real estate owned (REO owned by PennyMac refers to distressed loans that have worked their way through to foreclosure) make up over 50% of assets at the company.
The distressed assets have some hidden value. At the Keefe, Bruyette and Woods conference management showed the following slide pointing to the carrying value of their assets. The company carries these assets 68% of current collateral value, with the clarification that by current collateral value they are referring to the appraised market prices of the homes.
If you do the math, there is $620mm of embedded value in the distressed portfolio – or almost $10 per share not included in book.
The other interesting business that PennyMac is dipping their toes into is jumbo loan originations. While this business is still small (the company originated $8 million of jumbo loans in the first quarter, versus $5 billion in total volume), it will grow with improvement of the housing market, and the real opportunity is that once (if?) the private label market heals, the company can begin to securitize these loans, taking equity stakes in home loans near the bottom of the market.
Admittedly PennyMac is a bit of grab-bag of mortgage businesses, but I don’t think this is a bad time to be grab-bagging the mortgage industry, particularly where the businesses involved are not sensitive to higher rates. I expect to recognize returns from PennyMac through the dividend (which at the current share price is about 10%) with potentially further gains realized as the market recognizes that this company is not akin to other mortgage REITs and that there is significant value not recognized in book.
NorthStar Realty (NRF) is a bit different then the two aforementioned companies in that NorthStar generates a significant portion of its income from commercial real estate loans. NorthStar, however, is similar to the aforementioned companies in that they have been hit rather hard for their association with the term ‘mortgage REIT’ and the extrapolation that higher rates will be negative for the company, even while their assets are only minimally exposed to the impact of higher rates (on the most recent conference call the company said that a 100 basis point move in the 10-year would make zero difference to their cash available for distribution).
Northstar is a hodge-podge of commercial real estate lending businesses. They generate income from their owned CRE properties, which include healthcare (skilled nursing and home care facilities), lease properties (which are 77% office space), and more recently, manufactured housing. They generate fees and equity distributions on their legacy CRE loan CDOs. They generate some minimal fee income on the CMBS CDOs but most of these are performing quite badly. They have created three non-tradable REIT vehicles, two focused on commercial real estate and one focused on health care that offer their product to retail investors and to which NorthStar collects fee income. And they are opportunistic, as is witnessed by a recent investment in a private equity portfolio of commercial real estate that is expected to be accretive to cash flow by 6-7c in 2013 and 16-18c in 2014.
The investment case for NorthStar is the yield (which is around 10% at the current stock price) with the potential for price appreciation through one of the following events.
- A spin-off of fee generating assets
- Further clarity of returns on their more opaque investments such as manufactured homes and private equity interests
- Collapse of their CMBS CDO’s to free up cash for accreditive investment
- Accretive gains from a recently acquired private equity portfolio
The number of moving parts at NorthStar justifies a more detailed post in the future where I will dive further into the details. Each of the above points is worthy of a few paragraphs.
In addition to these specific events, NorthStar is also somewhat of a generic bet on the ability of management to create opportunities in commercial lending. A similar statement could be made for all three of these names. While each name has been chosen for the make-up of their portfolio, they have also been chosen for the quality of their management teams and I expect that as the economy and credit makrets continue to heal these teams will come up with more ways to create value for holders of the equity.