2022 was incredibly difficult for companies in the mortgage sector. Mortgage originators struggled as the Federal Reserve raised interest rates to combat hyperinflation. Those rising rates helped bring down origination volumes to about half of 2021 levels.
Mortgage real estate investment trusts (REITs) also struggled as their portfolios eroded their interest rate hedges, leading to a decline in book value per share. Mortgage companies holding servicing assets fared best. Rhythm Capital (RITM 0.42%) is a mortgage REIT that operates several businesses, and it goes beyond offering traditional mortgage lending.
Rhythm Capital is a mortgage REIT formerly known as New Residential. It operates several different businesses, including mortgage origination, mortgage servicing, and mortgage-backed securities investments, and is entering single-family rental and commercial real estate. In 2022, the mortgage origination business took a back seat to mortgage servicing, which accounted for 38% of revenue in the previous year’s fourth quarter.
mortgage servicing was the star of the show
Mortgage servicing is an unusual asset. A mortgage servicer performs the administrative duties of managing a mortgage on behalf of the investor. The servicer sends monthly bills, collects payments, pays principal and interest to the investor, ensures payment of property taxes, and deals with the borrower in the event of default.
The servicer is typically compensated 0.25% of the mortgage’s outstanding balance per year for performing these services. In other words, if the borrower has a $400,000 mortgage, the servicer would receive approximately $1,000 per year.
The right to perform this service is worth something, and the asset is capitalized on the balance sheet. Valuing Servicing is a complex business, and no two portfolios are alike. Things like the rate on the mortgage, the state, the credit score and the interest rate all factor into the estimate.
For the past one year, the servicing prices were increasing as the interest rates went up. Investors love mortgage servicing because its value increases when rates rise. This is because the incentive to refinance is gone, and the holder of the servicing agreement is expected to receive 0.25% of the mortgage balance for the longer term. Over the past year, Rithm’s servicing portfolio has grown from 1.25% to 1.65% of outstanding loans.
Of course, valuations can also fall, and this can happen when delinquencies go up or rates fall to bring back the incentive to refinance.
Origin is too low
The Genesis business suffered losses last year, perhaps more than the average for the typical promoter. Q4 2022 origination volume came in at $7.9 billion, a 43% decline from Q3 2022 and down 79% from a year ago. Rithm has historically been big in loans that are not guaranteed by the US government, which can suffer from spotty liquidity. When it was still new residential, it bought Caliber in 2021, which was the peak of mortgage origination volume.
Rithm is working to diversify into other ancillary businesses, including commercial real estate, title insurance, single-family rentals, and personal loans. Many of these businesses are still too small to compete meaningfully with origination and servicing, but they will help the company better manage the highly cyclical mortgage origination business.
Dividend is well covered, but servicing valuation is high
Rithm announced that Q4 earnings available for distribution came in at $0.33 per share, which covered a quarterly dividend of $0.25 per share. At current levels, Rithm is trading with a dividend yield of 10.8%, which is quite attractive. Book value came in at $12 per share, and the stock is trading at a substantial discount to book. This may be at least partially driven by the perception that servicing valuations have peaked and there is nowhere but to go down. Regardless, while other mortgage REITs are trading at a premium to book, Rythm is trading at a 21% discount.
The dividend is well covered, at least for the time being, and as long as delinquencies remain low, the dividend is probably sustainable. The mortgage origination space is still out of favor, and that will be a headwind for the stock.