I recently told you that sometimes companies do things that we have to question and a prime example occurred with the popular 10% yielding name Two Harbors Investment (NYSE: TWO) just last week. Recall it that this hybrid mREIT, meaning it makes its money from a diversified portfolio of assets and strategies in the real estate sector, announced its intention to spin off its portfolio of commercial real estate assets to Granite Point Mortgage Trust Inc. By spinning off all holdings from Two Harbors into Granite Point, the newly funded Granite Point will focus on directly originating, investing in and managing a portfolio of commercial real estate loans and other debt and debt-like instruments. Granite Point has filed a registration statement with the U.S. Securities and Exchange Commission with respect to a proposed initial public offering of its common stock. We discussed that Two Harbors plans to distribute its shares of Granite Point common stock by means of a special dividend after the expiration of the lock-up period following the completion of Granite Point's proposed IPO. While I concluded that this move will create value for shareholders, it still remains to be seen if the common share dividend will be impacted.
The dividend is a key component of this name. In fact, it is the primary reason we own mREITs. As many of you are aware TWO is an mREIT I have repeatedly had concerns over in the past, particularly as it pertained to the dividend. I urged investors to avoid it in the past. And this was correct as we watched as the share price plummet because performance was just not strong, especially compared to other names in the sector. For a long while, in fact, I have had concerns over the dividend payment. Finally, the dividend was cut, and I then continued to have concerns about the dividend at $0.23, but admitted this was wrong in December 2016 as the company astonishingly raised its payout to $0.24 and again to $0.25. It was able to do this because it made the changes necessary in its holdings to take advantage of market trends. In short, it was well managed. But guess what? TWO has once again done it! That is right, it just announced yet another dividend hike of $0.01, up to $0.26 per share.
How has this name been able to bring its dividend back to these levels? The answer is that performance has been strong, thanks to aforementioned portfolio management. When we turn to look at the performance and dividend coverage the name has significantly improved and those who held their nose and bought in the summer and fall are being rewarded. The change is evidenced by the Q1 results. IN fact, TWO actually outperformed the sector as the company saw comprehensive income of $145.7 million, or $0.42 per share, and net income of $72.0 million, or $0.21 per share. However, this GAAP number does not inform us about dividend coverage. The best gauge for dividend coverage is, of course, core earnings. I was looking for $0.25, which would be just enough to cover the dividend. As it turns out, they came in at $95.0 million or a strong $0.27 per share. This is the reason the dividend was able to be raised. The dividend was covered at is newly hiked rate, and then some.
Performance on earnings rose because of the underlying key metrics. The annualized yield on the company's portfolio assets was 3.99%, up from 3.54% in Q4 2016. However, the annualized cost of funds unfortunately rose 35 basis points to 1.52%. Even with this rise in costs, the improvement in yields let to the net interest rate spread widening. If we take the difference of these two variables, it results in a net interest rate spread that rose from 2.37% to 2.47%. Driving positive expectations going forward, the constant prepayment rate fell from 9.7% to 7.1% last quarter, and then fell again this quarter to 5.6%. That is critical. To top it off, book value rose to $9.91.
I have to be honest that this hike did surprise me. I thought that management would wait one more quarter before making another raise to the payout as a measure of safety. With this hike, I am bullish on the name, as it tells me performance in the current quarter must be strong. If management felt things were going poorly, there is no way the dividend would be hiked. It would be maintained, given the wise management team at this shop. Looking ahead, I expect the dividend to be covered for the rest of the year, and think that this name should be bought on pullbacks.
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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.