Description

mREIT Preferreds: NRZ Series C

As equity and credit markets run, I am increasingly hunting for places to safely camp-out, where I can earn an equity-like return without stretching too far out the risk curve. I believe a broad swath of Agency focused mortgage REIT preferreds fit the bill, offering 8-15% IRRs on a one to five-year basis. 

I’ve owned a wide variety of mREIT preferreds since last spring. During that time, the risk profiles have transitioned from “stressed/distressed” to “safe”. I’ve continued to opportunistically rotate and add, even as prices have rallied to reflect the improved credit profiles. These safe securities are amongst the highest yielding non-distressed assets in markets, and I believe are mispriced relative to their place on the risk spectrum.

Many mREITs are small cap companies and their preferreds are effectively microcap issuances, making them difficult for institutional buyers to acquire. That said, a decent-sized example of one I like today is NRZ’s Series C preferreds. NRZ’s market cap is $4.2 billion and the Series C preferreds are $400 million of par.

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I am not going to go in-depth on the nuances of NRZ’s business, as it’s only mildly relevant to the preferreds. With preferreds, there are really only two questions: 1) will it fail; and 2) what will the future cost of capital be? Given I don’t expect NRZ to fail, this write-up focuses on #2.

NRZ is a primarily Agency mortgage REIT, with a particular focus on servicing related assets (e.g., MSRs and servicer advances). In addition to its investment portfolio, as part of its business model, NRZ is vertically integrated with a number of operating assets related to origination and servicing, giving it elements of a Rocket Mortgage and a Mr. Cooper. These operating assets are valuable, but seem to be completely ignored by Mr. Market. As a result, NRZ is actively evaluating spinning off its operating businesses. Fortress has effective control over the business and NRZ’s CEO, Michael Nierenberg, is a de facto de facto Fortress employee.

As part of NRZ’s capital structure, it has three different preferreds: Series A, B, and C. In aggregate, the three series have ~$840 million of par value vs. common book value of over $5 billion. In that sense, they are well protected by a large subordinated equity buffer. I own bits of each of the preferred series, but find the C’s most compelling. 

I should note: I also own NRZ equity, which I’m happy to discuss in the comments.

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As you may know, most preferreds are retail products that capitalize on the tax advantages for investors related to dividends (vs. interest) and more flexible regulatory capital treatment. Most preferreds (including all of NRZ’s) have $25.00 par values. Beyond that, preferreds are anything but cookiecutter. Some are cumulative, others are not. Some are fixed rate, others are floating, and still others are both. Call (redemption) protection varies. Some preferreds are converts. The list goes on.

All of NRZ’s preferreds are cumulative and have a fixed-to-floating nature (they are fixed coupon initially, and then switch to LIBOR floaters once they become redeemable). Amongst its three preferred series, NRZ C’s trade at the lowest dollar price - $21.20 - because they have the lowest coupon. Initially, they pay a fixed 6 ⅜ coupon until February 2025. At that point, the preferreds become redeemable and switch to a floating coupon of L +  4.969%. At today’s Libor, that is a 5.2% par coupon. On a $21.20 purchase price, the fixed coupon yields 7.5% while the floater yields 6.1%.

That begs a view on question #2 above: what will the future cost of capital be? My view is that preferred yields across the Agency mREIT universe are too high and will grind lower. 

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The process of yield compression has been underway since early summer, and many mREITs have been redeeming higher coupon preferreds and replacing with lower cost capital sources. For example, in the past three months, we’ve seen Annaly redeem its Series D 7.5% fixed rate preferreds, Dynex (DX) announce the redemption of its Series B 7.625% fixed rate preferreds and Two Harbors (TWO ) announce it will redeem its Series D (7.75% fixed) and E (7.5% fixed). 

Further, we’ve seen price appreciation on preferreds across the board that indicates the cost of capital for new preferreds is coming down. 

Some examples:

• Bellweather mREIT, AGNC, has four preferreds, all of which have current yields <7.0%. Each of its remaining preferreds flips to floating in the next four years, and the implied yield on today’s prices for the floating period is between 4.6% and 5.3%. 

• Two Harbors will still have three preferreds outstanding after its redemption (Series A, B, and C), each of which flips to floating in four to six years. The floating yield at today’s price would be <6% (while the current fixed yield is 7.5% to 8.0%).

• Invesco Mortgage Capital (IVR) Series B’s (callable in 2024) yield 7.9% on the fixed, then 5.5% on the floater (L + 5.18% on a $24.50 trading price)

Depending on how large the mREIT is, I estimate the going rate for a new fixed-to-floating preferred is something like: 7.5% fixed for four years, then L + 5.5%. Four months ago, that cost of capital was nearly a full point more expensive.

NRZ C’s stated yields are below that estimate of the current cost of capital, which is why they trade at a discount to par. 

I believe the cost of capital will continue to grind lower, creating an opportunity to take slightly less current coupon, while owning a valuable option on future price appreciation.

Last March, Agency mREITs stared death in the face and never missed a preferred dividend payment. When the ciris first hit, MBS liquidity dried up, creating risk to repo lenders and price volatility - a toxic combination. As you know, the Fed stabilized the market as it began buying Agency securities by the boatload, including nearly half a trillion dollars in the first month of the crisis. It has continued to buy $100 billion per month since then.

All of the Agency mREITs used the incredible rally in MBS yields and liquidity in the market to heal and reduce leverage. Today, in aggregate, they are approximately as healthy as at any point in memory. This health coincides with less downside: the Fed and Treasury drew a target with MBS at the bullseye and said, “this is mission critical.”

The combination of healthier assets and de-risked liabilities means that mREIT preferreds live at the sweet spot of yield. They remain actual high yielding instruments, but have very healthy credit profiles. And those profiles continue to improve, as earnings continue to outpace dividends.

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NRZ’s Series C is one of the lowest coupon Agency mREIT preferreds in the market. By my lights, its low coupon is one of its most attractive features. 

Forgoing 1% p.a. of cash yield allows us to pick up 10-20% of total return opportunity. Unlike preferreds with 1% more coupon that trade at $24-$25, the C’s trade at $21. If they traded at $24, the opportunity to trade above par would be capped by the 2025 optional redemption. As it is, the ability to trade up toward par from $21 is what juices the return.

While nobody seems focused on it today, I value the floating rate optionality (particularly given LIBOR is already near 0% - implicitly there is limited risk of a substantial further decline). In a highly inflationary world, I can easily imagine rates rising. While governments may resist letting rates rise, due to the risk of triggering further macro issues, the possibility of rising rates certainly exists. In that world, not only might we benefit from NRZ C’s LIBOR floater, NRZ’s large servicing portfolio would likely gain in value, as prepayment speeds decline.

It is worth touching on NRZ’s business for a moment. 

I mentioned that its investment portfolio has healed, but “healed” understates the improvement: NRZ also owns a very large mortgage originator, and origination spreads widened out to record levels in Q2 2020 and remain very wide ten months later. This means originators are minting record profitability, quarter by quarter.  

As it relates to the operational suffering last spring, despite the carnage, NRZ never stopped paying common equity dividends, much less a preferred dividend (it did reduce common dividends). It also was able to raise capital from Fortress in the teeth of the crisis. While it was dilutive to common, it was wonderful for preferreds. 

With the US government erecting various backstops supporting the mortgage market throughout the spring, Agency mortgage REITs recovered rapidly. By October 1st, the operational issues were well behind everyone, and NRZ’s portfolio was right-sized and healthy.  

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In a world starved for yield, a spread of more than 5% over risk-free rates may someday be perceived as high. 

In that world, our $21.20 purchase price might accrete toward par. On the trip from $21.20 to $25, we would earn ~18% on the price increase plus the dividends collected along the way. If we assume it takes three years, that’s a low-teens IRR (400+ bps over long-term equity returns) for what I perceive to be lower-than-market risk. 

If the world remains balls-to-the-wall, risk-on, I believe the price appreciation can happen much faster.

On the other hand, if the economy tips over, between the GSE guarantees and Fed’s ongoing MBS purchases, I expect preferred coupons will be quite stable. While prices would likely decline, the coupon partially offsets the risk, and the preferreds will be comparatively “strong dollars” that we can redeploy into wherever the prevailing opportunity is. 

Risks:

Of course, risk always exists, and NRZ employs the standard mREIT model of running a levered mortgage portfolio. Further, as a large owner of Mortgage Servicing Rights (MSRs), NRZ is contractually required to make advances on behalf of delinquent borrowers. If everyone pauses at once, this can strain liquidity, though this risk has largely been mitigated by new GSE policy and large new servicer advance lines NRZ put in place during the past year.

In sum, I think we can earn a fairly low-risk, income heavy double digit IRR, over a 2-4 year timeframe.

I’ve decided to set up camp and hangout, while I assess the landscape.

Disclosure: I own NRZ equity and preferreds, as well as securities in other mREIT issuers. I may buy, sell, or exit without disclosing those changes. All investments are risky. Do your own work. I’m just a guy on the internet who does not merit your trust.

Catalyst

Peace a quiet driving ongoing spread compression.