2023-11-23 09:14:40 ET
Summary
- Rithm Capital trades at an 18% discount to book value, but offers a solid 10% yield supported by earnings available for distribution.
- The mortgage REIT is well-diversified, investing in various mortgage instruments, including residential loans, mortgage servicing rights, rentals, and commercial real estate.
- Rithm Capital has significant excess dividend coverage, with an EAD/dividend ratio of 232% in Q3'23 and 207% in the first nine months of the year.
- The high discount to book value provides downside protection.
Shares of mortgage REIT Rithm Capital (RITM) trade at an 18% discount to book value despite presenting dividend investors with a very solid 10% yield that is well-supported by the REIT's earnings. I believe that Rithm Capital is undervalued as well as underappreciated since the REIT has a well-balanced investment portfolio. Rithm Capital's large discount to book value is not justified, in my opinion, and it generates downside protection for the benefit of dividend investors!
Rithm Capital has a diversified portfolio that generates significant, recurring earnings
I have not worked on Rithm Capital before, but in October bought another mortgage REIT, Annaly Capital Management (NLY) due to the company's large discount to book value and exaggerated fears about the REIT's dividend yield: I Just Bought Annaly Capital, But Not For The 14.8% Yield .
Although there are differences between Annaly Capital's and Rithm Capital's investment portfolio, I believe mortgage REITs currently provide decent value as some of them, like RITM, still trade at exaggerated discounts to book value.
Rithm Capital is not an agency-focused mortgage REIT, like Annaly Capital, but has a much broader focus when it comes to mortgage investments. Rithm Capital makes investments in residential mortgage loans, mortgage servicing rights, rentals (single-family), consumer finance, commercial real estate and servicer advances... all of which serve to make Rithm Capital one of the most diversified mortgage REITs in the sector.
Origination and servicing is the REIT's largest segment and it generated a combined $330.6M in earnings in the third quarter. In the second quarter period, Rithm Capital earned 329.8M in earnings from this segment. Last year, origination and servicing generated just $158.0M in earnings (+109% Y/Y) and the growth is due chiefly due to a change in the value of mortgage servicing rights.
While other segments also generate income, the REIT is, and likely will, depend on origination/servicing/MSR-related income much more than on other services like consumer or mortgage loans. Importantly, Rithm Capital's business portfolio is rapidly evolving and has changed considerably in the last few years as the REIT acquired new businesses and broadened its positioning in the mortgage market. Going forward, I expect Rithm Capital to acquire new assets/businesses in the mortgage servicing and capital management segments to grow and diversify its existing revenue streams.
In the last year Rithm Capital benefited from higher interest rates because they caused a re-pricing of the value of mortgage servicing rights... a key investment of the REIT. The rise in MSR multiplies is obviously a favorable development, but only as long as interest rates stay high. A decrease in rates may lower MSR values and, possibly, Rithm Capital's income prospects. Even in the event of falling interest rates, the REIT has sufficient dividend coverage to ensure that the $0.25 per-share quarterly dividend will be paid.
Source: Rithm Capital
Rithm Capital's portfolio, as shown in the previous chart breaking down income streams, includes mortgage servicing rights which are rights whose values are positively correlated with interest rates.
In other words, when interest rates rise, so does the value of these mortgage servicing rights. As the name implies, these mortgage servicing rights are rights that allow a servicer to "service" mortgage pools (the right to collect and distribute money) for which they are getting paid a fee.
Mortgage servicing rights tend to generate stable fee income and the life of these fee stream expands during rising-rate periods since prepayments become less likely. From an investment return point of view, mortgage servicing rights are therefore attractive pro-cyclical investments for mortgage REITs. Rithm Capital owned $595B worth of mortgage servicing rights at the end of the third quarter that were valued at $8.69B.
Turning to the liability side.
Rithm Capital had total liabilities of $27.5B in Q3'23 and an equity value of $6.0B. The pandemic made a dent into the company's portfolio value, but the firm has managed to return to solid growth since. Rithm Capital's book value is also growing, as I will show in the valuation section further below.
Rithm Capital offers a well-supported 10% dividend...
Rithm Capital has considerable earnings power… and it shows in the mortgage REIT's coverage metrics. Rithm Capital posted $0.58 per-share in earnings available for distribution ((EAD)) in Q3'23 which showed a quarter over quarter decrease of 6%.
Regardless of the decline in earnings available for distribution, Rithm Capital's quarterly dividend of $0.25 per-share was well-supported: the mortgage REIT's EAD/dividend ratio was 232% in Q3'23 compared to 248% in Q2'23. In the first nine months of the year, Rithm Capital's EAD/dividend ratio, which again measures the degree to which the dividend is covered by the REIT's core earnings, was 207%.
Theoretically, Rithm Capital could raise its dividend of $0.25 per-share, but the REIT has opted not to do so, in part because it is pursuing business acquisitions. Rithm Capital lowered its dividend during the pandemic, but has since managed to grow the dividend back to $0.25 per-share. It has paid the same quarterly dividend since the fourth quarter of FY 2021.
Why Rithm Capital is cheap
Rithm Capital's shares are trading at an 18% discount to book value which raises question as to why, considering that the mortgage REIT has really impressive dividend coverage.
The reason for the large discount, in my opinion, relates to the mortgage REIT's unconventional investment portfolio that includes many different mortgage investments (loans, mortgage servicing rights, actual real estate etc)… which may make Rithm Capital harder to understand compared to more "straightforward" mortgage REITs with MBS investments like Annaly Capital.
Nonetheless, the 18% discount to book value seems inappropriate considering how well the dividend is supported by earnings available for distribution. Rithm Capital traded, on average, at a 25% discount to book value in the last year and is currently trading slightly above this average. Annaly Capital is trading much closer to book value (0.98X P/B ratio) and PennyMac Mortgage Investment (PMT), another mortgage-focused investment company, is trading at a 14% discount.
In the long term I believe RITM could revalue up to book value. However, I suspect that Rithm Capital's "more complex" portfolio composition relative to plain-vanilla mortgage REITs implies that investors will continue to apply a larger-than-usual discount to the company's book value.
My (personal) fair value estimate is nonetheless $12.32 per-share... which represents the REIT's book value. Before the pandemic, Rithm Capital's shares have traded at price-to-book ratio above 1.0X and the REIT's book value is growing...
Source: Rithm Capital
Risks with Rithm Capital
I am not sure that investors can or should expect the gap between price and book value to narrow as Rithm Capital has traded at a high BV discount for a long time. But this should not be a concern for those investors that chiefly want to buy into Rithm Capital for its large and well-supported 10% dividend yield. What would change my mind about Rithm Capital is if the REIT's margin between EAD and dividend narrowed significantly or if the mortgage REIT started to trade at or above book value.
Final thoughts
Rithm Capital may be a more complex mortgage REIT than other REITs in the industry as the company owns a wide mix of different mortgage investments, including mortgage servicing rights, loans and servicer advances, single-family rentals etc. However, the core value of Rithm Capital, in my opinion, is the excess coverage of more than 200%, based off of EAD, in both Q3'23 and in the first nine months of the year. The REIT's portfolio trades at a significant discount to book value which provides dividend investors with downside protection. The yield itself is magnificently covered and has, theoretically, potential to grow with a higher distribution!
For further details see:
Rithm Capital: A Magnificent, Bargain-Priced 10% Yield