Two Harbors Investment Corp. (NYSE:TWO) is a typical mREIT with a relatively secure and stable investment portfolio. Their cost of capital has been rising for 9 months now but the management is more than capable of handling it with the current portfolio and the profit margin is not shrinking but widening. The 3rd quarter results were good and the dividend coverage is acceptable at the moment. TWO is yielding over 11% which is an eye-catching number for income-seeking investors.
Two Harbors Investment Corp. operates as a real estate investment trust (REIT) that focuses on investing in, financing, and managing residential mortgage-backed securities (RMBS), non-agency securities, mortgage servicing rights, and other financial assets in the United States. The company is a mortgage REIT (mREIT) and it provides financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities (MBS). The lion’s share of TWO’s investment portfolio is in Agency RMBS and Mortgage Servicing Rights. The management is keen on maintaining the high percentage of RMBS and secured loans in the investment portfolio.
Source: Q3 2021 Presentation
TWO reported book value of $6.40 per common share, representing a 2.3% quarterly return on book value. EPS estimate was $0.2 per share while the actual Q3 results reported was $0.24 per share representing a 20% growth compared to Q2 2021. The company generated a comprehensive income of $45.2 million, representing an annualized return on average common equity of 9.1%. The management continued to grow the mortgage servicing rights (MSR) portfolio. TWO settled on $14.0 billion unpaid principal balance (UPB) generated through the flow-sale program and closed on $15.3 billion UPB through bulk transactions. The management also expects to settle on outstanding commitments of $21 billion UPB of MSR through bulk transactions in upcoming quarters.
Two Harbors’ President, CEO, and CIO says they want to deploy more capital to Agency-backed RMBSs and MRSs: “There was robust activity in our MSR program where we settled on $29 billion UPB during the quarter and committed to purchase another $21 billion UPB. With our recent capital issuances, we continue to position the company to deploy capital in MSR, and in RMBS as attractive opportunities arise.” Federal Reserve has already started to reduce its monthly purchases of U.S. Treasury securities by purchasing only $10 billion of it and purchasing just $5 billion of Agency RMBS beginning in November and expects to complete the process by mid-2022. We can also see that the cost of capital is slowly rising and the combination of higher mortgage rates and fewer number of financeable mortgages point to lower prepayment speeds ahead. Although the cost of financing is higher than a year ago and likely to increase due to the interest rate hike in 2022 the profit margin of TWO grows with it.
TWO is trading 7% below its book value which makes the stock a bit undervalued. Let’s compare TWO to its peers. Ellington Financial Inc. (EFC) has more than half of its portfolio in RMBS, MFA Financial, Inc. (MFA)’s portfolio is in RMBS while Starwood Property Trust, Inc. (STWD) has a more diverse portfolio but has a similar revenue to TWO. TWO has a forward Non-GAAP P/E ratio of 7.52 while its competitors have higher valuations. EFC has a forward P/E ratio of 9.37, MFA has a P/E ratio of 8.42 and STWD has a P/E ratio of 11.92 while the sector median is 11.23 but that includes all asset managers, BDC, and all types of REITs. Comparing the 4 companies’ prices to book value we can still see a bit undervalued stock but TWO has a quite similar ratio to EFC and a much higher valuation than MFA.
Source: Seeking Alpha
TWO operates in a highly regulated environment and is subject to the rules, regulations, approvals, licensing, reporting, and examination requirements of various federal and state authorities. There are also several competitors sharing the same marketplace.
While financial markets and mortgage delinquency levels have largely recovered to pre-pandemic levels, the losses incurred in connection with the company’s non-Agency portfolio are expected to have a long-term impact on their book value. In response to the pandemic, the U.S. government has taken various actions to support the economy and the continued functioning of the financial markets. In 2020, the Federal Reserve committed to purchasing unlimited amounts of U.S. Treasuries, mortgage-backed securities, municipal bonds, and other assets. In addition, the CARES Act provided billions of dollars of relief to individuals, businesses, state and local governments, and the health care system suffering the impact of the pandemic, including mortgage loan forbearance and modification programs to qualifying borrowers who have difficulty making their loan payments. Now, with the FED’s new initiative it will reduce its monthly purchases of U.S. Treasury securities also affecting TWO negatively.
The company purchases Agency RMBS that are protected from the risk of default on the underlying mortgages by guarantees from Fannie Mae, Freddie Mac, or, in the case of the Ginnie Mae, the U.S. government. If these GSEs fail to honor their guarantees, the value of any Agency RMBS that TWO holds would decline. The continued flow of residential mortgage-backed securities from the GSEs is essential to the operation of the mortgage markets in their current form, and crucial to their business model. Although any reform would likely take several years to implement, if the structure of Fannie Mae or Freddie Mac were altered, or if they were eliminated, the amount and type of Agency RMBS and other mortgage-related assets available for investment would be significantly affected. A reduction in the supply of Agency RMBS and other mortgage-related assets would result in increased competition for those assets and likely lead to a significant increase in the price for TWO’s target assets. A number of legislative proposals have been introduced in recent years that would phase out or reform the GSEs. As a result, market uncertainty with respect to the treatment of the GSEs could have the effect of reducing the actual or perceived quality of, and therefore the market value for, the Agency RMBS that the company currently holds in its portfolio.
Through the use of leverage, TWO acquires positions with market exposure significantly greater than the amount of capital committed to the transaction. It is not uncommon for investors in Agency RMBS to obtain leverage equal to ten or more times equity through the use of repurchase agreement financing. Subject to market conditions, the management anticipates that they may deploy, on a debt-to-equity basis, up to ten times leverage on their Agency RMBS; however, there is no specific limit on the amount of leverage that they may use.
The company qualifies as a REIT for federal income tax purposes. As a REIT, the company must distribute at least 90% of its annual taxable income to its stockholders. The company has been paying dividends for 11 consecutive years but has no consecutive dividend growth mainly because of the pandemic-related dividend cut in 2020. TWO has an astonishing forward dividend yield of 11.26%.
The company and the management maintain the 90% payout ratio. It seems sustainable with the current earnings and interest income. The rise of the cost of capital does not affect TWO which indicates the rate hike will not cause significant disruptions in earnings. That means the payout ratio is sustainable in the near future and that’s what matters to income investors. The above 11% dividend yield is because the stock price has not recovered from the July 2021 drop. It seems that due to FED’s purchase program ending and the 2022 interest rate hike the stock price is not going to recover those losses soon but maintain this 11% yield longer than previously analysts expected.
Source: The table is created by the author. All figures are from the company's financial statements and SA Earnings Estimates.
The company’s investment portfolio performs well but could be better. The management handles well the rise of the cost of capital and the profit margin (spread) rises with it which is a good sign for the upcoming interest rate hikes and the future change of LIBOR. The stock is a bit undervalued but only trades 7% below its book value so not a primary target for growth investors but the 11.26% yield could be a great choice for income investors.
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