New Residential Investment (NYSE:NRZ) is a real estate investment trust (REIT), which means that it is specifically structured to pass income through to investors. Historically speaking, it’s done a pretty good job of that, too, since it became a stand-alone entity via a mid-2013 spinoff. Only something just took place that will make dividend investors wince. Here’s what happened and how it changes the buy, sell, hold equation.
Not your typical REIT
The first thing that investors have to understand about New Residential Investment is that it is not a typical property-owning real estate investment trust. The company owns a portfolio of mortgages and mortgage-related securities and businesses. This is a very different business model from owning and operating a collection of physical assets, which is kind of a boring business that’s fairly simple to understand. The thing is, New Residential is even more complex than many mortgage REITs, which generally focus on just owning a portfolio of mortgages.
So what exactly does this REIT do? At the end of the first quarter, about 60% of the company’s business is tied to mortgage servicing. Effectively, a mortgage servicer sits between the mortgage owner and the homeowner, making sure that payments get made. This is a pretty stable business that generates reliable fees. The key here, however, is that the mortgage servicer is on the hook if the homeowner doesn’t pay up. That’s usually not too big a deal, but it can become an issue during extremely bad economic downturns.
Around 30% of the REIT is dedicated to owning mortgages and residential securities and call rights. Most mortgage REITs buy mortgages using leverage, with the profit being the difference between the interest generated from the mortgages and the REIT’s cost of capital. The risk here is that the mortgages that get acquired are usually used as collateral for the leverage the REIT uses. If the value of the mortgages falls dramatically, the company may need to come up with additional collateral or be forced to sell assets that have fallen in value. The company’s investment in call rights, meanwhile, provide it with the right to buy mortgage bonds if their values fall below a certain point. Effectively, it’s paying for the potential opportunity to buy mortgage bonds on the cheap.
The rest of the REIT’s business is classified as other or is related to originating mortgages and facilitating home buying transactions. All in, this is a very complex mortgage REIT in a niche that’s already pretty complicated compared to a plain vanilla property-owning REIT. And the explanations here have really only scratched the surface of what’s going on when you dig in a little more. But you don’t need to dig in much further than this to make an investment decision here.
What just happened
When times are good, New Residential’s business can be a very profitable one. Since it was spun off in 2013, it’s pretty much only operated in a good market (the last recession ended in 2009). However, when capital markets tighten up, things can go wrong pretty fast for mortgage REITs. Leverage plays a vital role in this. On the mortgage portfolio side, as noted above, falling values can cause margin calls as lenders seek additional collateral.
This helps explain why, as the market got ugly, New Residential quickly sold mortgage-related assets to reduce its exposure to mark-to-market financing risks. Its portfolio of mortgages, rights, and loans was worth around $26.5 billion at the start of 2020, but it had been trimmed to roughly $8 billion by the end of the first quarter. By the end of April, the portfolio had shrunk another billion dollars. Just a few months ago, the relative importance of the company’s mortgage servicing business, the size of which hasn’t materially changed, was not nearly as big as it is today.
The goal of what amounts to a major corporate makeover was to de-risk the portfolio as the market was facing a severe dislocation. In fact, the U.S. economy is now officially in a recession. So focusing on reducing risk was not a bad call, but it does have major consequences. The biggest one for dividend investors is that New Residential slashed its quarterly dividend from $0.50 per share to just $0.05. There really wasn’t much of a choice, however, because the company basically jettisoned most of its portfolio. The most upsetting piece of this, though, is that this economic downturn is the first one the company has lived through. In other words, it kind of failed its first big test, at least where dividend investors are concerned.
This is the big problem that should keep most investors away from New Residential Investment. It’s a very interesting REIT in many ways because of its diverse and complex portfolio. But that doesn’t mean it’s a good investment. Note that the complexity here didn’t help investors any when the U.S. economy hit a rough patch. When boring REITs like Realty Income and W.P. Carey are still rewarding investors with dividend increases, despite the difficult economic environment, why would a long-term investor want to invest in New Residential?
Just not worth the risk
At the end of the day, there are too many other options in the REIT world to bother with the complexity of New Residential. Add in the fact that, when the chips were down, the REIT reduced its dividend by 90%, and the desirability of New Residential falls even further. Most investors should avoid this complex REIT.