New Residential Investment Corp. (NYSE:NRZ) is a publicly traded real estate investment trust ("REIT"). It is externally managed by an affiliate of Fortress Investment Group LLC (NYSE:FIG). NRZ mostly invests in mortgage servicing related assets (e.g., excess MSRs and servicer advances), real estate securities and loans, and consumer loans. The company website has done an excellent job in explaining what these investments are, so I only briefly describe them here for completeness sake.
Each mortgage has to be serviced by a servicer to provide services including collection of payments, handling of foreclosure, mortgage modifications, providing liquidity in case of delinquencies, etc. In return, the servicer is compensated by a fee in terms of a percentage of the unpaid principal balance (UPB) of the mortgage and paid along with each mortgage payment. The right to service a particular mortgage in exchange for a fee is called a mortgage servicing right ("MSR") and is created during the mortgage origination. The fee is made up of two components:
- a basic fee: compensation for the performance of servicing duties
- an Excess MSR: the amount that exceeds the basic fee
This is best illustrated by a hypothetical case from NRZ's website:
NRZ, as a capital provider, does not provide servicing duties. It invests in MSRs to earn the fees from Excess MSR while sub-servicing the servicing duties to subservicers, which receive the basic fees of the MSRs. Since NRZ is only interested in the excess MSRs, NRZ usually refers to its MSR investment as Excess MSRs in its disclosure.
As a side note, subservicers earn some interest on mortgage payments because mortgage payments are usually paid by homeowners some time before the mortgage owners receive the payments. The higher the federal funds rate, the higher of the interest earned by subservicers in this manner. When a mortgage is repaid, an MSR loses all its value because there is no more UPB. The pricing of MSRs is thus subjected to prepayment and interest rate risk. In this sense, they are similar to interest-only strips of mortgages.
MSR owners have minimal credit risk because the amount due to them are small compared to the underlying property value of a mortgage, and they are getting paid before any mortgage owners. However, MSR owners have liquidity risk because they have to fund the mortgage payments, taxes, insurance payments and other foreclosure fees in case of delinquent mortgages before the properties are being foreclosed on to extract values from the underlying properties. An excess MSR owner does not have liquidity issues with regarding delinquent mortgages because the subservicer bears the risk.
Servicer advances are the liquidity provided by mortgage servicers (or subservicers in the case of NRZ) to mortgage owners. NRZ also invests in them to provide liquidity to subservicers in exchange for the basic fee component of MSRs. NRZ gets less profits if the mortgages associated with the servicer advances getting prepaid, but because the value of servicer advances represent real money due to mortgage and the duration expectation of servicer advances is short (about nine months), the book value of servicer advances do not shrink that much. The stability of servicer advances value allows NRZ to fund the servicer advances with borrowings at the cost of around 3-4% with over 10x debt to equity ratio so that NRZ can get superb leveraged returns. As of 2015, NRZ got a life-to-date IRR of 26% of its servicer advances investment from the year 2013.
As a side note, NRZ sets a target leveraged return of 14% for servicer advances. There is a threshold that servicers have to meet before earning their performance fees.
Real estate loans, securities, and associated call rights
NRZ invests in distressed real estate loans and securities (RMBS) opportunistically from time to time. NRZ also acquires call rights associated with the non-agency RMBS it owns in order to arbitrage the difference between the credit risk of the securities and the market price.
NRZ has invested in consumer loans by SpringCastle JV since 2013. NRZ since then invested more interest of the joint venture and became the majority owner.
As a mortgage REIT (mREIT), the total net interest income and expenses of the company do not tell us much about how the company performed. The focus should be on the per-share numbers like core earnings per share. The dividend is also a good indicator of the business performance because NRZ has the policy to distribute essentially most of the earnings that the management thinks the company had earned. They are shown in the following (from 2014 Q4 and 2015 Q4 supplements):
NRZ earned core earnings per share of $0.52 and $0.49 in 2016 Q2 and Q1 respectively. It also gave dividends of $0.46 in both Q2 and Q1. Simply speaking, things are moving in the right direction for NRZ.
From the 2016 Q2 supplement, we see how NRZ has allocated its equity in various investments:
As shown, most of NRZ's equity are invested in servicing-related investments: Excess MSRs and servicer advances.
Why is the company good?
The management has done an outstanding job in getting high-quality investments. For example, MSRs with lower FICO scores and higher loan-to-value are worth more because of lower prepayment rate expected due to the fact that they are less likely to be refinanced. The following shows the characteristics of NRZ's Excess MSR portfolio:
The characteristics of the Excess MSRs have indeed resulted in better performance-lower prepayment rate:
On the other hand, the execution of call rights on non-agency securities is a very smart way to earn a profit from an arbitrage between the credit risk of the securities and the market price, and it's illustrated in the following:
I honestly do not know if it's better for the management to execute these call rights to earn the arbitrage or hold on to the securities to continuously earn interest and the accretion of the discount to par value of the securities NRZ held. However, this kind of deal collapse opportunity shows the management has vast business relationships with a lot of different parties in the mortgage industry.
In 2015 February, amid the near-collapse of the Ocwen family companies, NRZ took the opportunity to acquire the HLSS business. The deal is accretive and is evidenced in 2015 Q4 core earnings per share being 10+% higher than 2015 Q2's. Besides, NRZ establishes a new servicing relationship with a large servicer by having Ocwen onboard.
In 2016 August, NRZ acquired an MSR portfolio from Walter Investment Management Corp (WAC), along with the assets of Walter Capital Opportunity, LP ("WCO"). The deal creates a servicing relationship with WAC, and a flow arrangement for future MSRs generated by WAC's loan originations. I doubt if this deal is accretive, given NRZ needed to issues shares at current depressed share price to fund the transaction. However, I believe it has very good strategic value because it secures another source of future MSR investments, in additional to the existing ones from Nationstar (NYSE:NSM) and Ocwen (NYSE:OCN).
These deals are splendid moves done by the NRZ's management in strengthening the business while being core EPS accretive.
I want to discuss a little bit more about the WAC deal because it is controversial due to the need to issue shares at around $14, which has 13% dividend yield. First of all, WAC was not in good shape as shown in its 80% collapse in share price since two years ago:
WAC's fundamentals were not moving in the right direction, either, as shown in its consistent negative GAAP EPS and disappointing adjusted EPS:
This situation did not allow WAC to get a good price for its MSR portfolio.
When we look at the price tag of the WAC deal, NRZ acquired $72 billion UPB of seasoned conventional mortgage MSRs at the price of $514 million. It's priced at 71 basis points of the UPB. Assuming the MSR portfolio only consists of Agency mortgages, the Excess MSR fee is around 19 b.p. (25 b.p. for the entire MSR, minus 6 b.p. basic fee for servicing). Assuming the lifetime of the MSRs is five years, the IRR is about 11%. Assuming NRZ has a cost of debt of 6% (its secured corporate note is at 5.67%), and the deal is roughly funded at debt/equity ratio of 2 to 1, leveraged return is 16%, which exceeds NRZ's dividend yield of 13% at the share issuance price. Besides, there is additional business relationship obtained from the deal, so I believe the management has done at least a fair deal, and at best, a terrific deal.
The performance of NRZ's investments is mostly macro-driven. The two biggest macro factors for the investments are interest rate and the general economy of United States.
The following slide from NRZ 2016 Q2 supplement shows what the management believes how NRZ's portfolio will perform with various interest rate environment:
While I believe NRZ can survive in an environment with a lower interest rate, NRZ will actually perform better in an environment with rising interest rate because it will reduce prepayment rate dramatically on its service-related investments. With the federal funds rate at 0.50% and WSJ Prime Rate at 3.50% currently, I believe the downside of interest rate is very limited. It will either stay flat or mildly increase in the foreseeable future.
Moving on to the economy, we can see the GDP growth rate in the following graph (from Trading Economics):
Some people may say US GDP growth is too low. However, I don't think the US needs a very high GDP growth to keep things going. As long as the GDP growth is positive, people can keep their jobs, and the risk of mortgage payment default will be low. In fact, the strength of the job market is evidenced by the following graph from CNBC that shows the unemployment rate for the past 10 years:
It does not matter you look at either U-3 or U-6; the trend is all going to the right direction.
With a strong job market, the involuntary prepayment risk of servicing related assets will stay low, and that is very favorable to NRZ.
The top three non-bank mortgage servicers in the United States are Nationstar, Ocwen, and Ditech (under Walter Investment Management). NRZ has business relationships with all of them, including subservicing and MSR flow deals. In addition, being one of the major capital providers in the mortgage servicing industry, NRZ has tremendous pricing power when negotiating deals with subservicers.
Furthermore, NRZ's subsidiary, New Residential Mortgage LLC, is in the process of becoming fully eligible to own Non-Agency and Agency MSRs in all states in the United States. The graph below from 2016 Q2 supplement shows the progress:
Being able to own MSRs without a servicing partner gives NRZ great flexibility in making MSR deals. It also gives NRZ a favorable position when picking its subservicers.
Outlook of the company
Before the WAC deal, the company had the capacity to get around $500 million from credit facilities, and the company had around $200 million in cash, so NRZ had a total of $700 million liquidity. After the WAC deal in August 2016, that costs $514 million, and a corresponding capital raise to sell 20 million shares at $13.98 per share, NRZ has around $450 million liquidity for future growth.
I believe the company can still invest in Excess MSRs and RMBS opportunistically. However, the increase in competition for MSRs and depressed NRZ share price limits the company to make large EPS-accretive deals, so I only expect stable income without much upside catalysts going forward.
That being said, the management believes there will still be plenty of MSR sales from both bank and non-bank servicers due to the regulatory environment:
- MSRs are capital-unfriendly for banks due to Basel III treatment of MSRs.
- It is very costly for non-bank mortgage servicers, which generally have a higher cost of capital than NRZ, to hold MSRs on their own. In fact, three top non-bank mortgage servicers: Nationstar, Ocwen, and Ditech, have transformed to a capital-lite, fee-for-service business model, in which they only involve in the servicing but not owning the MSRs.
What is the risk?
Macro-driven business model
Despite the management of NRZ being smart, NRZ's business model is mostly macro-driven. Prepayment can go up beyond the management control and the pricing of the servicing-related investments can become unfavorable due to intense competition. Also, any stress in the capital market may cause liquidity issues in NRZ, which needs a healthy capital market to fund its servicer advances and other investments.
The impact on Excess MSRs due to various macro factors can be found in the following disclosure in 2016 Q2 10-Q:
Simply speaking, for every 100 basis points increase in prepayment rate, 4% of NRZ's book value is lost. Unless the prepayment rate bounces back in a timely manner, the book value loss in such scenario will translate to earning power loss.
Management compensation misalignment
The company is externally managed, and it has an agreement with Fortress. The most relevant part of the agreement is about how the management is compensated. Basically, the management is paid annually with 1.5% of the gross equity, adjusted for certain items. Then, for the amount that exceeds 10% return on equity (the return uses core earnings adjusted for certain items), the management also gets 25% of that amount.
While the compensation is not excessive, it does not align shareholders' interest with the management enough. The management has no incentives to repurchase shares when the share price is low because it is compensated for the size of the equity of the company.
Additionally, the management is not obligated to give NRZ the best deals it found, because it has duties in Fortress as well. In other words, NRZ does not have a management that works full-time for its business.
I like to calculate a "buy limit" in valuation. A buy limit is the highest price that I would consider buying the share.
My minimum return of an investment is 10%, independent of inflation. Because NRZ does not earn more when inflation is higher, I will need to add 2% to my required return, thus 12%. Despite the fact that the company does not have any economic moats, I do not increase the required return beyond 12% at this point, mainly due to the current favorable macro environment. Besides inflation, several considerations come to my mind when reaching my decision on giving it a 12% required return:
- Superb management
- Favorable macro environment
- Being one of the major capital providers in the mortgage servicing industry gives it an edge
- The policy of distributing out essentially all earnings in dividends reduces reinvestment risk (e.g. the management deploys capital in low-return investments)
- macro-driven business model
- the management does not work for NRZ full-time
- the management compensation scheme does not align shareholder interests with the management no economic moats
Because of the bads, I do not recommend this stock for a part-time value investor. I believe NRZ investors need to track the macro environment closely to adjust the required return upwards when the macro environment is against NRZ.
Now, I will try to get the conservatively-speaking owner earnings (CSOE) of the company. I will start with the core earnings of $119.596 million in 2016 Q2, then deduct the incentive compensation $4.929 million. That results in $114.667 million. The annualized CSOE is thus $458.668 million. The 2016 Q2 has diluted weighted average number of shares outstanding of 230,839,753, so the CSOE per share is $1.98.
While I believe the management can make accretive deals to increase the core earnings, the management would get their hands tied if the macro environment is not favorable. For conservative sake, I do not add a perpetual growth assumption in my valuation.
Thus, the buy limit for NRZ is $1.98/12% = $16.50 per share.
Disclaimer: I am not a licensed investment adviser. As I have no knowledge of individual investor circumstances, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended. This article is for my personal opinion sharing and for informational purposes only - any opinion expressed in this article and elsewhere on the internet is not a form of investment advice provided to you. I use information in my articles I believe to be correct at the time of writing them, which information may or may not be accurate and may or may not be up-to-date. I am not liable for any losses suffered by any party because of any information published on this article. Beware, past performance is not a guarantee of future performance.
Disclosure: I am/we are long NRZ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.