Buy This mREIT Despite Headwinds
Adnan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
PennyMac Mortgage Investment (NYSE: PMT) operates as a specialty finance company that seeks to invest primarily in residential mortgage loans. The company has a market cap $1.57 billion, and for the purpose of reporting PennyMac is divided into two business segments; Correspondent lending and Investment Activities. Under its Correspondent lending function, PennyMac acquires newly originated loans from mortgage lenders, sell them to an Agency or a third party, or pools them into MBS and retains the mortgage servicing rights. Under the Investment Activities function, PennyMac invests in distressed mortgage assets, most of which are purchased at a discount to their par values, reflecting their higher risk of default.
Potential Headwinds
Among other risks PennyMac faces, a decline in the US home prices and credit risk of the portfolio are the most significant risks.
The underlying home prices are the primary determinant of the value of the loans and mortgage securities PMT holds in its assets portfolio. If the home prices begin to fall, the fair value of these PMT’s securities are likely to decline. In such a case, PMT is expected to incur significant losses on their asset portfolio, reducing their ability to pay dividends.
Since PMT has a large exposure to the US housing market, it will be exposed to the risk of borrower defaults resulting in a foreclosure and loss to the lender. As a result PMT would face losses on its portfolio.
Other risks include funding risk, regulatory risk, interest rate risk, and the risk to dividends. If the market experiences a downtrend and the fair value of PMT’s securities fall, PMT will be subject to margin calls. This will force the company to pay off a portion of its borrowings, causing negative impact on liquidity. If PMT loses the exemption from Investment Act 1940, the company would be forced to operate as a Registered Investment Company and would have to significantly curtail leverage, compressing dividends. Furthermore, rising interest rates would mean higher borrowing costs for PMT. The company’s dividend distribution comes from two sources; interest income and gain on sale of their MBS portfolio. If a large proportion of the dividends are coming from gain on sale of MBS than from steady interest income, downwards pressure on dividends will be experienced during down quarters.
Dividends
PennyMac offers a quarterly dividend of $0.57 per common share, yielding 8.5%. Competitor Newcastle Investment Corp (NYSE: NCT) is offering a dividend yield of 8.3%. PennyMac has increased its dividends 3.6% in November last year. This is in sharp contrast to the 10% dividend cuts by Annaly Capital (NYSE: NLY) and Armour Residential.
Valuations
In comparison to its peers, PennyMac is still attractively valued. The stock is currently trading at 33% premium to its third quarter book value, compared to 88% premium for Newcastle. Nationstar Mortgage Holdings (NYSE: NSM) is currently trading at 4.8 times its book value. Citigroup rates the shares of PMT a Buy with a $30 target, while the consensus mean price target is $27.30.
In contrast, mortgage REITs that invest largely in Agency securities are trading at discounts to their book values. American Capital Agency (NASDAQ: AGNC) and Armour Residential are trading at 3% and 10% discounts to their respective book values. Annaly Capital is trading at 11% discount to its third quarter book value.
Competition
Since PennyMac operates as a mortgage REIT that invests largely in non-Agency MBS, its closest peers include Newcastle Investment and Nationstar Mortgage Holdings. Newcastle Investment actively manages a portfolio of real estate securities, loans, excess mortgage servicing rights, and other real estate related assets. The company’s investment in real estate securities in spread across residential and commercial security types, providing the company sufficient diversification. The company has a market cap of $1.85 billion and offers a dividend yield of 8.19%.
Nationstar Mortgage Holdings has a market cap of over $3.3 billion and a well diversified investment portfolio. The company engages in servicing of residential mortgage loans besides originating and securitizing single family mortgage loans to government sponsored entities. The company’s recent announcement of its acquisition of sizable mortgage servicing rights, which were in the pipeline, is believed to positively impact future earnings.
American Capital Agency, Armour Residential, and Annaly Capital Management invest exclusively in Agency mortgage backed securities. American Capital’s recent earnings were positively impacted by a hike in assets yields, supported by a hike in the interest yielding assets during the quarter. Assets yields increased despite the challenging microenvironment, where the Fed is committed to keep the rates low and the yield curve flat. American Capital is believed to a highly prepayment protected portfolio, like Armour Residential. Armor Residential is offering a dividend yield of 13.6%, while it is trading at 7% premium to its book value. Armour Residential has a large concentration in 15-year mortgage backed securities. In contrast, Annaly Capital has a large concentration in 30-year MBS. Annaly Capital’s asset yields and net interest spread was compressed again during the most recent quarter. However, the management managed expenses well during the fourth quarter, which is why they declined 36%.
Investment Thesis
I am bullish on PennyMac despite the headwinds aforementioned. As the current opportunity in distressed whole residential mortgages subsides, I expect PMT to invest across all classes of the market. I believe PennyMac is well positioned to take advantage of the current distressed market opportunity and also to adapt as the US housing and mortgage market recover and evolve over time.
equityfinancials has no position in any stocks mentioned. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!
