The Quick Investment Case
New Residential Investment Corp. (NRZ) is one of the more interesting publicly traded entities I have examined. It is a REIT, spun off this year from another REIT (Newcastle Investment Corp.), and is managed by a separate entity, which is an affiliate of Fortress Investment Group. So you could describe New Residential as a spinoff REIT, which is managed by a hedge fund.
I am generally not a fan of REITs but I do like spinoffs, because of their documented tendency to outperform the overall market. I am agnostic about hedge funds but recognize the potential appeal of a hedge fund's investment skills. These skills are particularly important to New Residential, however, because there is one more interesting point about the company. Unlike many REITs, New Residential owns no properties. Instead, it invests in mortgages, mortgage-backed securities, and mortgage servicing rights. Many hedge funds are currently engaged in precisely the same activities.
The nutshell investment case for New Residential is its current dividend yield of more than 10% at a recent stock price of around $6.00, based both on Newcastle's pre-spinoff dividend prediction ($.61 per year), as well as on a full-year projection based on New Residential's first full quarter dividend ($.175; issued for 3rd Quarter 2013 per 3rd Quarter 10-Q). Further adding to the potential investment case is that comparable REITs have dividend yields, on average, of just over 7%. Thus, if New Residential is able to maintain its projected dividend for a full year at $.60 or more, the stock price could (emphasis on could) rise significantly to bring the company's dividend yield more in line with competitors. For now, there appears to be a premium built in to New Residential's dividend yield to account for the risk that dividends over the next three quarters will fall short of projections. The purpose of this article will be to assess how likely New Residential is to deliver on its projections.
It is also worth considering that, as I discuss in more detail below, New Residential's investment portfolio is positioned to benefit from increasing interest rates. To put this in perspective, the company's 3rd Quarter 10-Q states that, as of September 30, 2013, "a 100 basis point increase in short term interest rates would increase our earnings by approximately $5.8 million per annum." (10-Q, p. 63). While New Residential is somewhat hedged against interest rate declines, an investment in New Residential will position you "long" on interest rates.
New Residential came into existence as a wholly-owned subsidiary of Newcastle Investment Corp. (NCT), which is also a REIT. Newcastle spun off New Residential on May 15, 2013. Newcastle now describes its business as "opportunistically investing in, and actively managing, investments primarily in: (1) Real Estate & Other Debt and (2) Senior Housing." By contrast, New Residential describes its business as investing in: (1) excess mortgage servicing rights ("Excess MSRs"), (2) residential mortgage backed securities ("RMBS"), (3) residential mortgage loans and (4) other related investments.
I will examine these categories of investments in greater detail but with respect to Excess MSRs, Newcastle, through New Residential, was something of a pioneer. Specifically, in late 2011, Newcastle became the first REIT to obtain IRS approval to buy Excess MSRs. While Newcastle was first to the game, it is now one of several REITs investing in Excess MSRs. This suggests that other investment professionals saw Newcastle's idea as a good one. It also suggests that New Residential was spun off to pursue what was seen as an excellent opportunity.
What exactly are Excess MSRs? Here is a good description, courtesy of the venerable law firm, Skadden:
Typically, however, GSE policies and other factors require that the total amount of the MSR exceed the arm's-length reasonable compensation that the servicer would demand for its services. The excess servicing spread represents this excess. For example, the arm's-length reasonable compensation of a servicer may be 25 basis points of interest on the underlying pool of loans. If the servicer actually receives 35 basis points, then the servicer has an excess servicing spread of 10 basis points. The excess servicing spread therefore represents a passive investment in the interest component of a pool of mortgages, akin to an 'interest-only strip.'
"IRS Approves 'Excess Servicing Spreads' as a New Qualifying Asset for REIT Purposes," August 29, 2012, Skadden, Arps, Slate, Meagher & Flom LLP, Fred T. Goldberg, Jr., David F. Levy, David Polster, John D. Rayis.
Excess MSRs have drawn great interest lately in investment circles because many of the major mortgage servicers are banks, such as Chase, Citi, and BoA. Under the Basel III Regulatory Capital and Market Risk Final Rule (Basel III Accord), which the U.S. Federal Reserve Board adopted in June 2013, mortgage servicing assets were given unfavorable treatment -- they generally do not count toward a bank's Tier 1 capital ratio. However, a sale of such assets does increase Tier 1 capital. Although the Rule only went into effect this past June, it had long been available in proposed form. Thus, banks had already started divesting servicing rights, including Excess MSRs, before the Rule became effective. This divestment was the original impetus for New Residential's foray into Excess MSRs.
The importance of investing in Excess MSRs goes further, however. It is an investment, which generally increases in value as interest rates rise. This is due to the lesser likelihood of prepayment (due to refinancing) when rates increase. Prepayment of a mortgage with an Excess MSR coupon generally wipes out the Excess MSR. Thus, a portfolio of excess MSRs, which is partly valued by models predicting prepayment risk, should increase in value as interest rates rise. There is also some thought that Excess MSRs will be at a premium in coming years due to the greater difficulty borrowers will have in getting approved for mortgages, i.e. the pool of Excess MSRs will not grow that much.
New Residential recently released its 3rd Quarter results for 2013 and its 10-Q filing is full of useful information. The 3rd Quarter 10-Q states that "New Residential has entered into a management agreement (the "Management Agreement") with FIG LLC (the "Manager"), an affiliate of Fortress Investment Group LLC ("Fortress"), under which the Manager advises New Residential on various aspects of its business and manages its day-to-day operations, subject to the supervision of New Residential's board of directors." (10-Q, p. 7). This makes it clear that Fortress is running the show at New Residential. This is not necessarily a bad thing if you like Fortress.
What is also clear is that New Residential is a very nice client for Fortress, which gets paid by New Residential under a plan that somewhat resembles standard hedge fund compensation. Here, it appears to be a 1.5% / 25% deal. (10-Q, p. 33). The 1.5% is a guaranteed payment based on New Residential's total equity. The 25% is incentive compensation based on Fortress's performance and involves a complex formula, which I roughly interpret to be 25% of any gains in net income of more than 10%. (10-Q, p. 33). According to the 10-Q, New Residential owes Fortress $7.1 million for its services in 2013 through the 3rd Quarter (10-Q, p. 34). This compensation structure seems somewhat lucrative compared to similar REITs. For instance, Annaly Capital Management, Inc., the largest mortgage REIT, pays its manager (a related entity) just 1.05% of stockholders' equity as a management fee. (Annaly 10-Q, p. 33).
In a November 8, 2013 Press Release, New Residential also announced the appointment of two officers, Michael Nierenberg as CEO and Susan Givens as CFO and Treasurer. Mr. Nierenberg was formerly head of Global Mortgages and Securitized Products at Bank of America Merrill Lynch. If anyone should know something about mortgages, mortgage backed securities, and mortgage servicing rights, it would be the head of the operation at BoA - which has been the largest mortgage servicer in the country. Ms. Givens comes from Fortress.
Finally, lest any doubt remain, New Residential's 10-Q plainly states: "There are conflicts of interest in our relationship with our Manager." (10-Q, p. 80). The conflict is not only based on the incentive scheme for Fortress, but the fact that New Residential is involved in mortgage servicing agreements with Nationstar (also managed by Fortress), consumer loans with Springleaf (managed by Fortress), and other co-ventures with Fortress funds themselves. (10-Q, p. 80). Consequently, if you do not like Fortress, either for its acumen or otherwise, you will probably want to avoid New Residential.
One could argue, however, that Fortress is incentivized to boost New Residential's net income. Fortress could also admittedly be incentivized to increase total equity in any manner necessary to improve its guaranteed compensation. Whichever way you view it, an investment in New Residential is a bet on Fortress.
New Residential earned $.24 per share in the 3rd Quarter of 2013 and $.72 for the year through end of 3rd Quarter. (10-Q, p. 2). It also announced a 3rd Quarter dividend of $.175. (10-Q, p. 2). Assuming that this dividend holds for the next three quarters, then New Residential's yield will be well above 10% at its current price of around $6.00. It is also above the $.61 annual dividend, which Newcastle predicted for New Residential in a pre-spinoff presentation.
Given that its current yield is well above those of comparable REITs (the presentation mentioned above lists a comparable dividend yield of 7.2% for competitors), it appears that there is a relatively substantial risk premium built into New Residential's stock price. Which means that the stock price may rise appreciably, if New Residential can maintain its projected dividend level. So, the question for a potential investor in New Residential is whether that most recent quarterly dividend of $.175 is a standard that the company can continue to meet. If it is, then the stock looks underpriced compared to competitors.
Whether the most recent dividend and earnings are aberrations is a very difficult question to answer, however, given New Residential's myriad investments in such things as mortgage securities and mortgage servicing rights, whose cash flows are affected by interest rates and whose values fluctuate based on predictive models assessing prepayment risk, default risk, and delinquency rates, among other factors. In other words, something of a black box that is dependent on multiple variables.
But let's take a look at New Residential's specific investments. According to the 3rd Quarter 10-Q, this is the breakdown of New Residential's assets (10-Q, p. 1):
Real estate securities, available-for-sale 1,861,200
Investments in excess mortgage servicing rights, at fair value 307,568
Investments in excess mortgage servicing rights, equity method investees, at fair Value 358,032
Investments in consumer loans, equity method investees 192,498
Residential mortgage loans, held-for-investment 33,060
Cash and cash equivalents 172,203
At first glance, New Residential somewhat resembles a standard mortgage REIT. Why? Because it has almost $2 billion in mortgage backed securities, which are referred to above as "real estate securities." It also holds actual residential mortgage loans, which we know from the 10-Q are reverse mortgages, although these are an almost negligible portion of the overall portfolio.
A closer look at the 3rd Quarter 10-Q reveals, however, that the mortgage backed securities on the balance sheet are of two types: "Agency ARM RMBS" and "Non-Agency RMBS." (10-Q, p. 14). As explained in the 10-Q, both of these types of RMBS are expected to increase in value should interest rates rise. (10-Q; p. 37). The main purpose of these holdings does not appear to be income, however, but rather a hedge against the increased borrowing costs New Residential will face when rates rise. (10-Q; p. 37). Like mortgage REITs, New Residential relies on repurchase agreements to fund many of its purchases and, of course, to assist in increasing its leverage. Short-term financing such as this is subject to interest rate risk and New Residential's portfolio of RMBS is designed to offset this risk. Of course, this is not a perfect hedge, as the RMBS may not move in lockstep with interest rates.
With this at least partial hedge understood, we can better see the directional bet that New Residential has made with Excess MSRs, which are generally regarded as having a positive correlation with increased interest rates because prepayments (which often wipe out Excess MSRs) are predicted to be lower as rates rise. Indeed, New Residential tells us that, as of September 30, 2013, "a 100 basis point increase in short-term interest rates would increase our earnings by approximately $5.8 million per annum" and would have a corresponding $.3 million impact on book value (presumably in either direction, based on the direction of interest rates). (10-Q, p. 63). This is a very interesting piece of information to find on the 63rd page of a 10-Q. It puts numbers to the concept that increasing interest rates will positively affect New Residential's performance, while decreasing rates will have a negative effect.
Finally, New Residential shows almost $200 million in assets related to a consumer loan portfolio. These loans are described as "personal unsecured loans and personal homeowner loans," in the 10-Q. Not very revealing. Only 10% of these loans are adjustable rate, however, so they seem to be a bet on continued economic improvement (and borrowers' attendant ability to repay loans), as much as they are on increasing interest rates.
Understand New Residential for what it is: a vehicle designed by Fortress to generate huge profits if interest rates increase. The company does some hedging against falling interest rates but New Residential is net long increasing rates. If rates decline significantly, losses may be very substantial. But one could credibly argue that interest rates do not have too far to fall from here. What if rates remain the same for an extended period? That is a tougher call, given all of the various investments held by New Residential. New Residential will likely have a more difficult time outperforming in a static interest rate environment. But New Residential does not need to perform any better than it is now for you to collect a 10% dividend yield or, possibly, enjoy stock price appreciation, which lowers the yield.
In all, if you are looking to make a levered bet on increased interest rates and trust the expertise of Fortress, then New Residential may be a good investment. The fact that it is a recent spinoff only adds to its attractiveness. Finally, if interest rates do rise significantly, knowledgeable investors may flood into New Residential in order to capitalize on the company's positioning.