Weighing Risk Vs. Reward For Newcastle Investment Corp. And Its 12% Dividend

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Newcastle Investment Corp. (NCT) gets lumped together with the mortgage REIT crowd, but this REIT stock offers a very different way to profit and earn a fat dividend from the mortgage securities market. The current business model of Newcastle provides the company with avenues for income growth and future dividend increases. This is in contrast to the agency MBS investing REITs, which are at the mercy of the yield curve when it comes time to determine distributable cash flow. As the 12% yield indicates, Newcastle Investment carries some risk, but if the mortgage market unfolds as the company expects, investors may do very well with shares of this outside-the-box finance REIT.

Newcastle Investment went public in October 2002. The company's business model was leveraged investing in low investment-grade or high non-investment grade collateralized mortgage obligations - CMOs. The CMO business was a hot financial sector until the financial crisis and the Newcastle share price increased from the IPO price of $13 per share to a peak of over $32 in early 2007. The quarterly dividend climbed from 40 cents quarterly to a high of 72 cents paid for the last three quarters of 2007.

Newcastle's management saw the problems coming in the CMO markets and all of the 2008 earnings conference calls discussed the company's steps to reduce its outstanding recourse debt and build up a cash cushion. However, the preparation was not enough to handle the severity of the mortgage derivatives meltdown and Newcastle was hit hard. By early 2009, Newcastle was a penny stock with the shares trading below 30 cents. The dividend was suspended in the second half of 2008. For 2008, the reported earnings were a loss of over $55 per share due to portfolio value write downs. Newcastle was almost de-listed from the NYSE. For the next three years the company worked to clean up its portfolio holdings and spent cash flow buying back its own CDO debt at pennies on the dollar. The dividend was resumed in July 2011 with a 10 cent per share distribution.

At this point, Newcastle Investment owns a $3.8 billion portfolio of real estate secured securities. Two-thirds of the portfolio is commercial real estate loans and securities in the form of collateralized debt obligations - CDOs, one-quarter is residential mortgage backed securities and the balance is corporate debt. As of the first quarter of 2012, this securities portfolio was valued at 79.5% of par - the $3.8 billion. The average coupon rate of the portfolio is 5.95%. The portfolio is leveraged with $2.8 billion of financing costing 2.71%. For the 2012 first quarter this portfolio generated $27 million out of the total $29 million of reported cash flow.

The extra $2 million of cash flow is from a new type of revenue stream for Newcastle and represents the start of a very interesting potential for increased cash flow and higher future dividends. The company has started to invest in excess mortgage service rights - MSR - from large pools of residential mortgages. Mortgage service rights are the portion of mortgage interest paid which goes to the mortgage servicing company. For the first $10.4 billion pool of mortgages in which Newcastle purchased an interest, 31.4 basis points - 0.314% - go towards the MSR. Servicing the mortgages cost 8 basis points and Newcastle purchase 65% of the excess 23.4 basis points. The dollar amount of servicing rights decrease as mortgage in the pool are paid off and can be stabilized if the mortgage company servicing the loans recaptures the rights through the refinancing of home loans in the pool.

If everything works as planned - a significant question - Newcastle will earn 17% to 18% on its investments in excess MSR. The actual returns are affected by the realized mortgage prepayment rates and the refinance recapture rate. Since the end of the first quarter, Newcastle has announced two more excess MSR investments. Company management has projected that this revenue stream could eventually account for as much as 40% of the REIT's distributable cash flow.

A final note for investors before some investment guidance. The reported GAAP net income and even core earnings include a lot of non-cash-flow items. It is better to keep an eye on cash available for distribution, which increased to $19.6 million in the 2012 first quarter, up from $15 million a year earlier.

Newcastle Investment declared and paid a 20 cent dividend for the first quarter, up from the previous 15 cents. The 20 cent distribution represented basically 100% of distributable cash flow. Company management believes the new excess MSR investments can add up to a nickel per share per quarter in cash flow. So that is the goal for investors: to hold on to the shares with the plan to ride the income as share growth to a steady 25 cent quarterly dividend. If that comes to pass and the yield drops below 10%, the share price should increase by 50% to $10. If the dividend is not up to 25 cents by the first quarter of 2013 or is reduced for any quarter, it is time to sell and lock in a profits or limit losses. This is a speculative investment with the potential for a nice gain over the next year, but there is plenty of risk included in the assumptions.

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