New residential: potential for appreciation in the short to medium term (NYSE: NRZ)


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I wanted to start 2022 by giving readers a quick overview of my biggest non-index fund positions and a rationale for why I think they will outperform. Today, I will champion the cause of New Residential Investment Corp. (NYSE: NRZ) which is my third most important position.

The stock was beaten in the COVID crash, falling to around $ 3.43 per share as the company was forced to divest assets to avoid a margin call. Since April 2020, the stock has gained nearly 147% with dividends reinvested, against a consistently impressive return of 89% for the S&P 500 (SPY).

New residential portfolio

Chart comparing the performance of NRZ to that of the S&P 500 (SPY). Source

An initial investment of $ 10,000 in early April 2020 would give you current dividend income of $ 1,970 for a return on cost of almost 20%. However, I think NRZ’s current quarterly dividend of $ 0.25 per share representing a 9.3% yield is still very satisfying for income investors who missed the boat and are looking to invest today. There is also reason to believe that the quarterly dividend rate could soon be raised to at least $ 0.30 per share, which would give an 11.1% still well hedged. I am accumulating shares in the troughs, despite my already significant participation.

Business model

New residential economic model

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Many readers and a disappointing number of writers do not seem to fully understand what NRZ does. Yes, it is classified as a Mortgage REIT, but it is a hybrid REIT that is incredibly diverse with its assets and operations. Many mREITs are simplistic, simply playing the spread between short-term and long-term rates, holding huge amounts of agency and non-agency mortgage-backed securities, and hoping that the yield curve does not turn. does not flatten or invert. Since 2019, NRZ has moved away from the volatile holdings of the market valuation agency MBS to become a well-diversified financial services company.

Overview of the new residence

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New Residential creates its own mortgages, service loans and holds management rights, has recently entered the single-family rental business and has just completed an acquisition of Genesis Capital, marking its entry into construction, la renovation and other residential bridging loans. Some people claim that all of these different segments of the business make NRZ a “black box,” something that cannot be fully understood or properly evaluated. While I understand the apprehension, I think this offers two huge benefits: a self-funded flywheel effect on the portfolio, and greater resilience to interest rate changes (both ways).

Reasons I think the market is wrong on NRZ

Rising interest rates and their MSR portfolio

NRZ is sometimes thrown in with the bathwater due to its designation as a mortgage REIT and the mainstream idea that rising interest rates are bad for mREITs. NRZ is one of the exceptions, as mentioned earlier, where NRZ’s book value increases as its large MSR portfolio enjoys a longer cash flow life. This is because NRZ has the ability to collect the service fees for these mortgages, but loses that ability if the owner refinances with another company. Here’s a breakdown of the fees and alleged valuation of their portfolio:

New residential MSRs

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The valuation of the $ 549 billion unpaid principal balance portfolio at $ 6.5 billion, with average fees of 0.33%, is a multiple of ~ 3.6x. This valuation multiple is up slightly compared to the last quarters despite the absence of any real lasting trend in rates. In the third quarter of 2020, when the NRZ was in trouble, rates were around 2.9% on a 30-year fixed mortgage. Why have the multiples increased if the rates have come down to the same level?

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As MSR balances amortize and are replaced on the balance sheet, older underlying mortgages that carried a higher coupon are replaced with new mortgages with a lower rate (NRZ was on average 3, 06% on mortgages issued during the last quarter). Even with stable rates, the amount of attractive “in the money” mortgages that are candidates for refinancing will decline. Since the second quarter of 2021, the percentage of their mortgages at rates above current rates has increased from 40% to 29%. This is clearly seen with the amount of depreciation occurring in the portfolio. In the third quarter of 2020, NRZ was amortizing more than $ 500 million, compared to only half, $ 250 million, in the last quarter.

As the average life of mortgage assets on their books increases, MSRs may achieve a higher valuation multiple. For more details on the hazards of MSR assessment, I recommend you read this article by Seeking Alpha contributor Matthew Utesch. During the conference call, CEO Michael Nierenberg estimated that a multiple increase of 1.0x (up from 3.6x) would result in an increase of about $ 1.50 per share in book value. Obviously, the company wouldn’t take advantage of all this bullish movement without some of its other assets losing value due to their hedged nature, but it is a reminder of how much value has to be unlocked on the balance sheet. I can’t fathom the increase in book value we should expect from MSRs in Q4, but with the 30-year fixed rate dropping from 2.9% to almost 3.4% today, I guess that would be important.

Return to growth mode

I think the market is confusing core earnings growth for NRZ as simply reverting to valuing its old assets, much like how the NAV of CLO Oxford Lane Capital (OXLC) shareholder is doing. is improved quarter after quarter as the reset to face value of the leveraged loan index has declined.

Remember that NRZ had to divest some of its legacy assets and the pandemic shock accelerated the transition of its business. NRZ now devotes half of its assets to significant growth through the origination and service activity, the single-family rental portfolio and the bridging loan with Genesis Capital. The shift from $ 0.31 per share to $ 0.44 per share in core earnings is largely due to the new business model, and not just ownership of RMBS. The move from a 14% mREIT to a growth machine above 9% is both welcome and expected. As we see continued earnings growth, the history and reputation of NRZ will change, and I wouldn’t be surprised to see yield drop to at least 7-8% in this low-yielding world we find ourselves in. let’s find. At current dividend rates, that would be priced from $ 12.5 to $ 14. If NRZ increases its dividend soon, as the CEO expects, we could see the stock price go above $ 15 in the medium term.

With core earnings currently at $ 0.44 per share and expected to continue growing, increasing the dividend to $ 0.30 per share per quarter would still leave them plenty of room. As the company diversifies and expands its operating activities, the volatility of its earnings will decrease. Book value per share may still fluctuate, but cash flows will be more independent of interest rates. 99% of their assets are now undervalued and the company has $ 1.9 billion in cash, should we see future market turmoil. That’s why I think NRZ is among the safest, high-yielding stocks left, and why I want to keep building my position before Mr. Market catches it.

Summary

NRZ has pivoted to become a well-diversified financial services company that combines earnings growth, high yield, and the potential for short- to medium-term share price appreciation as it revalues ​​higher. The downside risk is protected by more than $ 1.3 billion in liquidity, a complement of naturally hedged activities and a portfolio of assets stemming from a historically low interest rate environment (dissuading the risk of refinancing). The upside is bountiful as the company pays a high dividend yield with a low payout ratio, earnings growth looks certain and book value is expected to rise due to the steady rise in interest rates and the hawkish stance of the company. Fed.


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