New Residential Investment Corp And The Yield On Excess MSRs

| About: New Residential (NRZ)

Summary

NRZ is the most common mREIT among reader requests.

The excess MSRs in the portfolio are creating a very attractive yield on assets at a time when negative duration is fairly expensive.

The excess MSRs do contain some unique risks because NRZ must rely on the servicer to do their job.

I’m going with a question mark as my rating on NRZ because there is a lack of comparable investments to establish relative attractiveness.

New Residential Investment Corp. (NYSE:NRZ) is by far the most common mREIT to come up when readers are requesting more coverage for a specific company. It is also a more difficult mREIT to analyze, which is precisely why there is less coverage despite the presence of shareholders who would love to know more about the company. Despite the mREIT being more difficult to evaluate, I'm going to try to put it on the list more often.

The Three Segments

NRZ identifies three segments they want to use to drive risk adjusted returns:

Click to enlarge

These segments they are discussing are not the normal allocations for the mREIT industry. The investments in excess MSRs and call rights are particularly unusual in my opinion. These are investments that I rarely see on an mREIT's balance sheet. Because these assets are so unusual, it is exceptionally difficult to establish comparable valuations for NRZ to determine whether the shares are priced at attractive levels of unattractive levels.

While some analysts may be happy to perform their valuations in a vacuum, I believe valuation of mREITs is almost entirely a game of relative valuation. If I only had the data on a couple of mREITs, it would be extremely difficult to make any reliable calls to buy or sell a security. Since most mREITs have very few moats for their business, the primary valuation method is to assess the attractiveness of the portfolio at the current price and compare that investment with the attractiveness of investing in the other mREITs.

Excess MSRs

The excess MSR has some very favorable aspects such as a negative duration that causes it to increase in value when interest rates increase. The mREIT purchases the excess MSR and then simply collects the cash flows as they receive a small portion of the interest payment off the mortgages without having to perform the MSR duties. Whether the excess MSRs are a good investment or not will primarily be a function of how long the underlying mortgages last. The cost of the excess MSR will be amortized over time, but cash payment to acquire the asset was already made.

Amortization

I wanted to take a quick moment to state that the way principal is recovered is a little strange. At times it is referenced as accretion in the financial statements.

In the financial statements published by NRZ, there are cash flows related to the excess MSR that are categorized under cash flows from investing activities with a "return of investments in excess mortgage servicing rights" of $112,648 (in thousands), and an operating cash flow classified under "other operating cash flows" for interest received from excess MSRs in the amount of $84,518 (in thousands). Both of these values are for the 9 months (not 3) ending September 30, 2015.

Because amortization is a more commonly used and understood word, I will continue to refer to this process as amortization throughout the article.

Net Investments

The following slide is provided to demonstrate the net investments and targeted yield from those investments.

Click to enlarge

The one thing I really don't like about that presentation is that many shareholders might assume that the entire portfolio was represented by that pie chart. That would be inaccurate. The total of the slices is about $3.13 billion. The book value of common equity was $2.8 billion at the end of the third quarter and the total value of equity including non-controlling interest was $3.03 billion. On the other hand, the total asset portfolio was valued at over $15.3 billion.

The assets can be easily seen on the balance sheet:

Click to enlarge

The allocations in the balance sheet are clearly substantially different, which makes sense since some of the assets would be more difficult to finance than others. The allocations to excess MSRs are clearly very material at about $1.67 billion combined. That is over half of the market capitalization. The other major investment categories are the servicer advances and "real estate securities, available for sale." The area I want to focus on is the excess mortgage servicing rights.

Producing Income

The valuation of the excess MSRs declined during the third quarter as interest rates declined, which is perfectly reasonable. The total value of the position did not change too materially though. Therefore, I divided the interest income for the quarter by the asset value for the total MSR position (including their equity method investments). The result was a quarterly yield of 2.30%. On an annualized basis that would be 9.2%. This isn't going to keep up with the dividend yield by itself, but it is an exceptionally strong yield for an investment that has negative duration.

Investors may point to leverage, but I would expect the excess MSR to generally be financed through equity. If the mREIT can use the fact that they have this extra equity available to encourage other parties to lend to them with different assets posted as the collateral, then the excess MSR could fit very nicely in the portfolio.

Remember that one of the major drags on the earnings of an mREIT is the substantial cost of the net interest expense on swaps that are used to create negative duration for the portfolio. NRZ is able to create a material amount of negative duration through an asset that is yielding around 9% per year rather than creating a realized loss through net interest expense in each quarter. Overall, that looks fairly solid.

Investors attempting to perform this math with their income on the position over the first 3 quarters would come to an incorrect yield because the size of their position increased substantially between the start of the year and June 30th. As the size of the position increased, the amount of income it generated also increased.

Recapture Agreements

NRZ uses recapture agreements with their mortgage servicers to protect them from the risk of the mortgage servicer helping the customer to refinance. When the customer does refinance, the cash flow stream to NRZ would end. The recapture agreements assure NRZ that in that situation they will receive the excess MSR on the new loan, which would be very attractive. Unfortunately, if a different mortgage originator creates the low the recapture agreement won't be able to protect NRZ. As a result, NRZ simply has to estimate what percentage of excess MSRs will be recaptured when customers refinance.

Anything Else

I do want to point out that the excess MSR has a very unique risk factor as it exposes the mREIT to the possibility of the servicing making poor decisions and harming NRZ. If the servicer were to lose the right to service the portfolio, it could be severely detrimental to NRZ. This is a unique risk that must be weighed against the benefits of an asset that creates a substantial positive yield with negative duration.

Prepayment Risk

There is still a material amount of prepayment risk in the portfolio. If rates moved down significantly at the long end of the curve (which has been happening lately), it could result in a much higher prepayment rate that would decrease the expected life of the excess MSR asset.

Rating

I'm going with the most ambiguous of ratings, the question mark:

The issue here is that there is a lack of excellent comparable investments for NRZ which makes it substantially more difficult to base valuation of a comparison to other mREITs. The most likely way for NRZ to really succeed in a portfolio would be to combine it with another more traditional mREIT that has very different risk factors and to monitor the positions and occasionally modify the ratios of the two. I am specifically not using the word "rebalance" because the appropriate ratio of the two to generate the least total risk could change materially over time as a function of changes in both the interest rate environment and in the portfolio compositions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.