Description

New Residential Investment (NRZ)

Executive Summary

NRZ is a misunderstood spin-co, unfairly lumped in with agency mortgage REITs, trading at an ~11% dividend yield, with assets earning mid to high teen ROEs. Unlike most mortgage REITs, NRZ’s portfolio is positioned well for a rising rate environment, something which is clearly not well understood by the market. Over the next several months, we think investors will get more comfort in the story and the stock is poised for meaningful capital appreciation in addition to the robust current yield. At a 9.5% target dividend yield, the stock would be worth $7.35 for a total return of ~30% in a year. A higher ‘top up dividend’ announcement will be made any day now.

Company Background

NRZ is a mortgage REIT that was spun out of Newcastle (NCT) this spring.  You can read ele2996’s write-up of NCT from April 2013 describing both the spin and brief descriptions of both NRZ and new NCT. Briefly, Fortress (FIG) which is the external manager felt that the asset mix at legacy NCT was too complex and was trading at a material discount to its sum of the parts. NRZ is focused on residential & consumer assets, whereas new NCT is focused on CDOs and senior housing properties.

Portfolio Description

NRZ’s primary asset is a set of mortgage servicing rights (MSRs) which they own in conjunction with Nationstar (NSM) who services the mortgages on their behalf. Technically, this relationship means NRZ owns an Excess MSR, but the value of the asset works like an MSR that they would own entirely, net of the servicing fee shared with NSM. That is to say, they get a monthly cash flow from the interest payments on the underlying mortgages for the life of the mortgage until it is refinanced or paid down. As you can imagine, the biggest risk is prepayments, as they shorten the life of the MSR cash-flows. The good news is that prepayments should decreases in a rising rate environment, and NSM is set up to ‘recapture’ pre-payments by originating the new loan if the customer so chooses. The special relationship they have with NSM is contractual and should be evergreen.  In addition, the large banks continue to be sellers of their MSRs given the changing capital requirements under Basel III as well as the simple desire not to be in the business of servicing mortgages, just originating them.

NRZ owns non-agency RMBS (in conjunction with FIG/NSM) where they have special ‘clean up rights’ to collapse these RMBS securities and sell off the underlying loans to create value. Non agency RMBS prices should continue to benefit from rising housing prices.

NRZ owns a huge portfolio of agency RMBS as well – which on the surface doesn’t look great. However, once you net the repo debt against it you can see that equity devoted to agency RMBS is only 3% of the total. So why do they own $1bn of agency RMBS which should be dilutive to overall ROE? They need to for 1940 Act requirements. In essence, for a mortgage REIT to get the Section 3 (c) (5) (C) exclusion to the 1940 Act, they need to have 55% of assets consistent of ‘qualifying interests’, a category of assets which includes whole-pool agency RMBS. The remaining 45% can be ‘real estate type interests’ which would include the MSRs.

Finally, NRZ owns some consumer loans in conjunction with FIG entity Springleaf (LEAF) which they got in a great deal from HSBC earlier this year. Specifically, they bought a set of loans at a discount to face with a 20% IRR target but based on recent performance look to be earning in excess of 30%. FIG has said they will continue to look for opportunistic investments like this for the NRZ vehicle. Obviously, they like having a permanent capital vehicle so they are incented to source such deals in the future.

Reasons for the valuation discount are overblown

• People fear a secondary – NRZ filed an S-11 and has made several amendments to it in recent weeks, including name Credit Suisse as their underwriter. The market fears that they are looking to do a major equity offering which has become an overhang. The reality is that as a new firm, they needed to put out this shelf just so they can eventually issue equity when they need it down the road. Conversations with the company suggest they don’t need to do an equity offering in the near term and they certainly don’t want to issue stock near the 52 week lows and give their investors a lump of coal before Christmas. Our view is that since the stock trades above book value, any equity raise is actually accretive to book, assuming it can be put to work quickly in attractive assets (which is the story the company will certainly tell).
• They didn’t earn their dividend in Q3 – when the company came public people were expecting an annual dividend in the 55-60c range (see the April 2013 NCT pitch for example). In Sept, they announced a quarterly dividend of 17.5c, or 70c annually. People believed that they must be exceeding their underwriting expectations on the most recent deals and that they would earn that dividend in Q3. However, they only reported 15c of core EPS in Q3, which a disappointment. The reality is that earnings were held back given ‘cash drag’ and the company made several investments subsequent to the quarter closing in Sept, something they mentioned on their earnings call but should have highlighted in the press release. We think it is simply foolish to think NRZ declared a dividend on 9/18 with the Sept quarter all but finished that they knew they were on a run-rate to earning. Rather, the more sensible explanation is that as of late Sept they looked at the current pipeline of investments they were making and set the dividend accordingly, versus doing it on a backward looking trailing basis. In fact, in conversation with investors Wes Edens had made it clear that they will
  earn and then hopefully exceed the dividend in coming quarters.
• People see the agency RMBS exposure and freak out – as noted above, these are hold primarily for regulatory reasons, not to earn a huge spread like a traditional agency mREIT. They keep their assets very short dated and with floating rates. Therefore, they should note lose much money in a rising rate environment. To wit, they barely lost any money on this portfolio in May-July 2013, whereas companies like NLY took major hits to book value.
• The lucrative MSR trade is feared to be over – returns may trickle down but there are still trillions of mortgages (in terms of unpaid principle balance) to be sold. That means a lot of supply for the existing players which should means prospective returns aren’t competed away.
• NSM blew up, so that must be bad for NRZ – NSM had a disappointing Q3 and the stock has sold off sharply, that is true. But NSM issues are in the origination side of the business (where they take a gain on sale on writing new business) not servicing legacy mortgages. The relationship between NSM and NRZ is as strong as ever for the part of the business that matters to NRZ.
• They are somehow overearning (this sounds extra bad when you think they aren’t even earning the current dividend) – if you go through the current portfolio asset mix and expected returns you get to something like a high teens blended ROE and that isn’t considered sustainable, in part b/c of the fear that MSR returns will come down. I think there is some truth to that but think a 14-15% ROE, net of fees, is sustainable. In part this is due to the fact that currently they don’t lever their MSRs. The company has talked about that as a possibility as the asset class gains more maturity, they could get financing secured by those assets or simply borrow at NRZ holdco where they have a line of credit. In other words, the current dividend of 70c requires them to earn a 14% ROE, which I think is sustainable, and they can grow both book and the dividend by issuing equity above book.

Catalyst