The mREIT industry faces tremendous challenges and uncertainties, and I will not recommend mREIT stocks in general. However, I can recommend a new residential investment holding rating (NYSE: NRZ). No because it is safe from what is to come, but because I see it better positioned for the difficulties ahead.
First, it should be more resilient to rate changes than the average mREIT sector due to its diversified revenue streams. Its loan origination and MSR sectors react in opposite ways to movements in interest rates. Second, a combination of book value recovery and price corrections has brought its valuation below book value (0.84 times book value at the time of this writing). This is a discount of nearly 25% from its historical average of 1.1 times book value, which provides a significant safety margin here.
The current macro environment
Its chief executive Michael Nierenberg summed up the current macroeconomic uncertainties very well in the May 3 earnings report:
The macro environment, there are no secrets here. Inflation at multi-year highs. The Fed will raise rates, we expect, by 50 basis points this week. Geopolitical uncertainties continue to aggravate market volatility and macroeconomic concerns. I highlighted the 2-year and 10-year Treasury yields, which they did during the quarter. Credit spreads, once again, widened significantly, doubling their level in the fourth quarter of 21.
Notably, the 2-year and 10-year Treasury bond yields mentioned by Nierenberg are shown in the chart below.
As you can see, the spread between 10-year and 2-year Treasury yields fell below 0% in April. And the dreaded yield curve inversion happened briefly. The spread has rebounded a bit at the current level of 0.21%, still a nervously thin level for me. To put this in historical context, the last time the yield curve inverted was towards the end of 2019. And we all know what followed: the recession of early 2020. The Inverted Yield has always been a reliable signal of recession, and it is a possible scenario this time too.
Even without a recession, a narrowing yield curve can also put enormous pressure on the profitability of the mREIT sector, and NRZ is no exception. Also, I see a good chance that the yield curve will narrow further from here, as discussed in my previous article here,
Now, with the Fed’s hawkish cut and expected interest rate hikes, there are a few possible outcomes. Again, remember that the Fed only controls short-term rates. Long-term rates can change in any way (stay unchanged, increase more slowly, or increase faster than short-term rates) and lead to an expansion or contraction of the yield spread.
Unfortunately, the spread is heading in the direction of contraction so far. And according to the Fed’s dot chart, the short term interest rates will gradually increase to reach the level of 2.5% to 3% in a few years. I expect the long-term rate to rise no more than that, i.e. stabilize between 2.5% and 3% in the long-term as well (long-term rates ultimately cannot outpace inflation or GDP growth – otherwise our government would have solvency problems). This means that the shrinkage is likely to continue and put further pressure on NRZ’s profitability.
Then the next question is how prepared is NRZ for a narrowing of the yield gap as shown below.
Is the NRZ prepared for a high throughput environment?
In short, NRZ is better prepared for a higher rate environment than the average company in the mREIT industry. Thanks to its recent acquisition of Caliber, it now has two large, diversified revenue streams that respond in opposite directions to changes in interest rates. The first stream includes mortgage origination activity typical of the mREIT industry. Earnings from this sector are typically under pressure from the yield squeeze as it takes advantage of the short and long-term credit spread. The second stream consists of the MSRs. NRZ now holds the largest portfolio of MSRs among non-banks. And the rising rate environment will lead to increased profits for this segment. As Managing Director Michael Nierenberg commented (emphasis added by me)
I will tell you today that we are positioned for much higher rates. MSR, as I have already pointed out, 626 billion dollars, a industry-leading MSR portfolio, will increase in value as rates rise. We saw the results of that in the first quarter. Our origination franchise continues – will continue to be focused on buy-and-take, Baron will talk about that in a moment. The assets we have on our balance sheet that have a positive duration are all hedged against rising rates.
The financial statements certainly support the CEO’s comments above. As you can see from the following graph, last quarter it reported a strong increase in maintenance and MSR revenue. The increase was $788 million, from $118 million in the fourth quarter of 2021 to the current level of $906 million. While at the same time, revenue from the mortgage origination segment decreased by $56 million.
Valuation and Projected Returns
Thanks to its diversified earnings streams and hedges against higher interest rates, it has achieved healthy book value growth and stable core earnings. Book value increased to $12.56 per common share as of March 31, 2022, representing a recovery of 9.8% from December 31, 2021. Basic earnings were $177.4 million or $0.37 per diluted share, comfortably covering the dividend of $0.25 per share.
Due to a combination of the recovery in book value, stable earnings and recent price corrections, its valuation is now at an attractive level, as you can see from the chart below. In terms of price-to-book ratio, the most important metric in my opinion for mREIT, comes in at just 0.84x. To put it into a broader historical perspective, the stock has traded on average at 1.1 times its book value over the past decade. Consequently, the current valuation is almost 25% below its historical average. The valuation also looks attractive in terms of PE ratio (around 4.6x) and also dividend yield (9%+ in particular).
Summary and other risks
I won’t recommend mREIT stocks in general given the uncertainties ahead, but I can recommend a holding rating for NRZ. I expect it to weather the challenges ahead better than the average mREIT sector. Its loan origination and MSR segments enable a hedging mechanism. Its substantial discount to book value (around 16%) and to the historical average (around 25%) provides a margin of safety here. Finally, more than 9% of the current dividend yield also provides support.
Finally, there are other risks besides the interest rates mentioned above. The likelihood of a recession has increased significantly in recent quarters as rising inflation and globalization-related uncertainties deepen. Stocks with flagship status such as Walmart (WMT) and Target (TGT) all reported headwinds due to inflation and rising costs last week. On the housing front, there are also huge uncertainties. Inventories are extremely low, housing prices may have already passed highs and affordability is under pressure. As an mREIT player, NRZ will be sensitive to these broader economic conditions as well as housing market parameters.