Big-dividend mortgage-related REIT, New Residential (NRZ), is down 16% in the last few months while the overall market (SPY) is still up. This article explains why it fell, what will likely happen next, and we conclude with an attractive income-generating options trade that you may want to consider.
Overview:
New Residential makes money by investing in high yielding mortgage related assets such as Mortgage Servicing Rights (MSRs), residential securities and call rights. This continues to be a profitable business because the company is able to borrow money at a much lower rate than the rate NRZ earns on its investments. We wrote about this in detail multiple times, for example in this detailed article back on December 31st.
New Residential shares had rebounded dramatically since that December 31st article (as we predicted), but now they have sold off sharply again for many of the same reasons. Specifically, the shares have sold off for the following reasons
Interest Rates: As interest rates continued to rise as the housing crisis (2008-2009) moved further into the rearview mirror, NRZ was benefiting. As we described in detail in our previous article, NRZ often bragged about being one of the few assets that benefited as interest rates rose (this is mainly due to MSR valuations increasing as mortgage prepayment speeds slowed—people are less likely to pay off or refinance a mortgage when rates are going higher). However, that changed in the last several months as the market has changed from anticipating the Fed to increase rates, to now expecting the Fed to cut rates. This is not been beneficial for NRZ, and it is part of the reason the share price has recently fallen.
Credit Spreads: A credit spread is basically the difference between the interest rates on riskier higher yielding assets and lower yielding safer assets such as US Treasuries. And not only are treasury rate expectations coming down, but the interest rates required on riskier loans/assets are going up. When the market panics (as it has been recently) credit spreads widen, and this is not good for NRZ. For example, in last years annual report, NRZ noted that “a 25 basis point increase in credit spreads would decrease our net book value by approximately $186.4 million”). Credit spreads have recently been widening moderately, and this has put downward pressure on NRZ’s share price.
Changing Business Model: Another reason NRZ shares have sold off is because the business model of the company is evolving over time, and it has some investors nervous. For example, as the housing crises continues to move further into the rearview mirror, less distressed assets are available for purchase at attractive distressed (low) prices. One way NRZ has been evolving is through the purchase of mortgage servicers (for example they just acquired mortgage servicing business from Ditech), and this will allow them to actually service some of the mortgages upon which they have mortgage servicing rights if mortgage servicing becomes required. Not only do the acquisitions (e.g. Ditech) put pressure on the share price, but it also causes the shares to sell off as some investors are uncertain about the ongoing NRZ business evolution.
New Preferred Share Issuance: Also worth noting. NRZ recently issued new preferred shares to help fund business growth and evolution. However, the new preferred shares are ahead of the common shares in the capital structure, so this puts more (temporary, one-time) downward pressure on the common share price.
What Happens Next:
In our view, the NRZ fears are currently overblown, and the share price will eventually revert higher. Things could still get worse before they get better, but we believe they will eventually get better (the share price will revert higher) because the interest rate changes are baked in, credit spreads will eventually narrow again, we have confidence in management to lead the business evolution as the market continues to change, and the downward pressure from the new preferred shares was a one off one time event. In fact, the Wall Street analysts covering NRZ agree with us, as 100% of them currently have “BUY” recommendations on the stock, as shown in the following graphic.
source: FactSet
Specifically, they believe, on average, the shares are worth $18.71 each, giving the shares more than 32% upside from here!
Income-Generating Options Trade:
If you are attracted to NRZ’s big dividend yield (currently 13.3%) then you might consider buying shares now (we own them). But if you are afraid the market may still have farther to fall before it gets better, then you might considering selling out of the money put options instead. We will get into the specific details on this trade in a moment, but it basically allows you to generate very high upfront income now, and the big risk is that you may get the shares put to you in the future (you’ll have to buy them) at a much lower price, if the price falls further before the options contract expires. Here is an explanation of the trade…
The Trade:
Sell Put Options on New Residential (NRZ), with a strike price of $14.00 (just 3.2% out of the money), and expiration date of September 20, 2019, and for a premium of $0.20 (this comes out to approximately 17% of extra income on an annualized basis, ($0.20/$14 x 12 months). This trade not only generates attractive income for us now, but it gives us the possibility of owning shares of NRZ, at an even lower price if the shares fall even further than they already recently have, and they get put to us (and we’d be happy to own NRZ, especially if it falls to a purchase price of only $14 per share).
Your Opportunity:
We believe this is an attractive trade to place today and potentially tomorrow as long as the price of NRZ doesn't move dramatically before then, and as long as you’re able to generate annualized premium (income for selling, divided by strike price, annualized) of approximately 15%, or greater.
Important Trade Considerations:
Two important considerations when selling put options are dividends and earnings announcements because they can both impact the price and thereby impact your trade. And in NRZ’s case, they are largely non-issues. Specifically, NRZ isn’t expected to announce again until November 6th (after this put option expires). And second, NRZ isn’t expected to start trading ex-dividend until the end of September (also after this options contract expires).
Conclusion:
NRZ shares have sold off sharply recently due to interest rates, credit spreads, the evolving business and the new preferred share issuance. In our view, the market has overreacted, and the shares are way too cheap (and 100% of the Wall Street analysts covering the stock agree with us). We already own shares of NRZ, but if you don’t (or if you want to own more shares) you might consider placing the income-generating options trade in this article because it generates significant income for you up front (that you get to keep no matter what) and it gives you the possibility of purchasing shares of this big-dividend mortgage REIT at an even lower price if they get put to you before expiration. As a general rule, we like to keep our position sizes below 5% of our total portfolio (or 10% in rare instances), so consider how big your position size will be if the shares get put to you. And as a specific view, we believe NRZ’s shares are significantly undervalued right now. Things could get worse before they get better, but in the months and years ahead, we believe NRZ’s share price is going higher, perhaps significantly higher.