Income investors looking for yield should take a look at the mortgage real estate investment trust (REIT) market. Mortgage REITs often throw off double-digit dividend yields, and this is one sector where such a yield is not necessarily a warning flag. That said, mortgage REITs will face a headwind from the Federal Reserve going forward. One such mortgage REIT is Two Harbors (NYSE: TWO), which has a 10.6% yield and trades for book value per share. Is the stock a buy?
Mortgage REITs are different
Mortgage REITs are a different type of investment than the traditional REIT. Most REITs develop properties and then rent out the units. For example, office REITs build skyscrapers and rent out the office space. Mall REITs develop shopping malls and rent out the stores. They borrow money to develop the properties and then earn rental income.
Mortgage REITs don’t buy properties -- they buy real estate debt (in other words, mortgages). In this sense, the mortgage REIT more closely resembles a bank than it does a traditional REIT, which follows the landlord/tenant model. Mortgage REITs borrow money at low interest rates and invest the proceeds in higher-yielding mortgage-backed securities.
Two Harbors invests in government-guaranteed mortgage backed securities
Two Harbors invests primarily in mortgage-backed securities, which are guaranteed by the U.S. government. These securities are usually issued by Fannie Mae and Freddie Mac. These securities generally have lower yields given the fact that principal and interest payments are backstopped by the U.S. government.
For example, in the quarter that ended on June 30, 2020, Two Harbors' investment portfolio yielded 2.72%, and its cost of borrowing was 0.79%. The difference between those numbers represents the net interest margin, which is the income it uses to pay dividends.
Mortgage servicing rights increase in value as interest rates rise
Two Harbors also invests in securities called mortgage servicing rights, which are one of the most unique financial assets out there.
Mortgage servicing involves handling the administrative tasks of the mortgage. The mortgage servicer will collect the borrower’s monthly payments, make sure property taxes are paid on time, and will handle delinquencies and foreclosures. The servicer is paid 0.25% annually for providing this service. The right to perform that service is worth something, and it is valued as an asset on Two Harbor’s balance sheet.
Why would a mortgage REIT want to hold mortgage servicing assets? Mortgage servicing rights have an extremely unusual characteristic in that they increase in value as interest rates rise. Bonds go down when rates go up. Stocks do the same thing (hence the old market saw: Don’t fight the Fed). The ability of mortgage servicing rights to increase in value gives Two Harbors a hedge against rising rates.
The Fed is not on your side as an investor in this stock
The hedge against rising rates is important for two reasons. First, the Fed forecasted roughly a 50-50 chance of a rate hike in 2022. Second, the Fed has been buying mortgage-backed securities since the early days of COVID in an attempt to support the economy. The September 2021 FOMC statement was taken as a warning by the market that the Fed will start reducing its purchases of mortgage-backed securities.
This reduction could put pressure on mortgage-backed securities pricing, which would impact Two Harbor’s book value per share. During the 2013 “Taper Tantrum,” agency mortgage REITs like Two Harbors suffered heavy losses and cut their dividends. While a repeat of 2013 doesn’t appear to be in the cards, mortgage REITs will be vulnerable.
So, is Two Harbors a buy? At its current levels, it is trading right at book value per share of $6.42. The stock pays a quarterly dividend of $0.17 per share, which gives the company a dividend yield of 10.7%. I would be more excited about the stock if it was trading at a bigger discount to book value.
Mortgage REITs generally trade right around book value per share and become attractive when trading at a high single-digit discount to book. If I already owned Two Harbors, I would hold it, but I wouldn’t reach for it at book value per share. The next six months to a year will not be a friendly environment for the mortgage REITs, especially those that hold government-guaranteed paper.