Why Rising Rates Helped New Residential Increase Book Value
The first quarter of 2022 was expected to be particularly brutal for mortgage originators and mortgage real estate investment trusts (REITs). The Fed began a series of hikes in the federal funds rate aimed at curbing rising inflation. At the same time, the Fed is about to let its holdings of mortgage-backed securities decline.
Rising rates are bad news for mortgage originators, and falling demand for mortgage-backed securities is bad news for mortgage REITs. New Residential (NRZ -1.76%) managed to report an increase in earnings and book value per share. So what are they doing differently?
A highly diversified mortgage company
New Residential operates three core businesses. First, it invests in mortgages and mortgage-backed securities and earns interest income from these investments. This is the typical mortgage REIT model. Second, New Residential operates a mortgage origination business where it purchases completed loans from independent mortgage originators and then resells them in the market through securitization transactions. Finally, New Residential is a mortgage loan servicer, and this line of business accounted for a large portion of the company’s earnings in the first quarter.
Mortgage servicing rights are an unusual asset because their value increases as interest rates rise. Here’s how they work. When a mortgage loan is entered into, there are two assets that can be separated and sold separately. The first is the loan itself, which an investor will hold to collect the monthly payments. The second is the Mortgage Service Fee, which represents the right to handle the administrative tasks of the mortgage for a fee.
Mortgage management performed well in the first quarter
The mortgage agent handles mundane tasks on behalf of the ultimate investor in the mortgage loan. The servicer sends out bills and monthly statements, collects the money and forwards it to the investor, ensures property taxes are paid on time, and deals with the borrower if the loan becomes delinquent. If the borrower ends up defaulting, the repairer takes care of the foreclosure.
In exchange for performing these functions, the repairer receives a fee (usually about 0.25%) or a quarter of one percent of the outstanding mortgage balance per year. If the borrower makes the monthly payments on time, servicing is quite an easy task. A repairman looking after a $400,000 mortgage will be paid about $1,000 a year.
When interest rates rise, the repairer can expect to collect these service charges for longer. This is because it doesn’t make sense for a borrower to refinance the loan because the rates are higher. No one will refinance a 3% mortgage with a 5% mortgage. This gives more value to maintenance.
For New Residential, servicing accounts for 60% of first-quarter revenue, which is split between servicing fees and an increase in the value of its servicing portfolio. In the fourth quarter of 2021, maintenance accounted for only 28% of revenue. Total services revenue increased from $310 million in the fourth quarter of 2021 to $1.03 billion in the first quarter of 2022.
The dividend is well covered
This increase in mortgage servicing also resulted in a 10% increase in book value per share to $12.56 per share. The quarterly dividend of $0.25 was well covered with basic earnings of $0.37 per share. At current levels, New Residential is paying an 8.7% dividend yield, which is pretty solid considering the earnings. The entire mortgage REIT and mortgage origination industry is suffering from a difficult macroeconomic environment and lackluster investor sentiment, but New Residential managed to increase book value per share by 10% amid a rate hike. The new residential is worth a look for income investors.