Redwood Trust: Book Value Likely To Decrease, But Not As Much As Agency REITs

Redwood Trust (NYSE:RWT) has an over 20% return since I placed a "Buy" rating on the REIT in May. With other mortgage REITS struggling, let's take a closer look at the name ahead of its Q3 earnings.

Company Profile

As a refresher, RWT is a specialty finance company that is classified as a REIT (real estate investment trust). It operates in three segments.

The firm has an investment portfolio consisting of largely business purpose lending (BPL) loans and prime jumbo residential mortgages. It also has investments in other RMBS, CRT, Freddie Mac K-Series multifamily loan securitizations and reperforming loan securitizations, and home equity investments.

Its Business Purpose Mortgage Banking segment acquires or originates business purpose lending (BPL) loans that are then sold, securitized, or transferred into its investment portfolio. BPL are loans given out to investors in multifamily or single-family rentals, and can either be term loans or bridge loans.

RWT's Residential Mortgage Banking segment, meanwhile, purchases jumbo loans, which it then puts in its investment portfolio, sells them to whole loan buyers, or securitizes them through its private label platform.

The company also has an investment vehicle that invests in early-stage fintech, real estate technology, and other companies.

Q2 Earnings Results

For Q2, RWT recorded EPS of 0 cents. That compared to EPS of -85 cents a year ago.

Adjusted earnings available for distribution was 14 cents per share. That compared to 11 cents in Q1 and

Its net interest income was $26 million versus $40 million a year ago. NII was $26 million in Q1.

Book value fell to $9.26 from $9.40 in Q1, a -1.5% decrease. The company paid out a 16-cent dividend, down from 23 cents last quarter.

Looking ahead, the RWT's management was very excited about regulatory changes happening in the banking industry and how it would positively impact the firm.

On its Q2 earnings call, CEO Christopher Abate said:

"Fast forwarding to today, we are witnessing yet another round of policy changes in Washington that will kick off this next era of the mortgage market. The outgoing era, characterized by a 41% increase in home prices since 2020, was fueled by extremely accommodative Fed monetary and government fiscal policy in response to the COVID-19 pandemic. With benchmark Fed rates reduced to effectively 0 during this period, banks had an almost limitless supply of deposit capital to lend as the country battled COVID. Many banks chose to opportunistically put that money to work in 30-year jumbo mortgages. And these mortgages were predominantly held in portfolio for investment rather than distributed into the capital markets. These mortgage portfolios proved to be sound credit investments and posed a little principal risk to the banks, but the interest rate mismatch between the 30-year loans and the deposits funding them was undeniably significant, and in many cases, very risky. Even as benchmark Treasury bills gapped from near 0 in January 2021 to over 5% in March 2023, the perceived stickiness of deposits compelled many banks to continue offering mortgages to preferred clients at rates well below market. In fact, prior to the onset of the regional bank crisis this past March, depositories originated 2/3 of all jumbo mortgages in the first quarter. As we take stock of the situation today, the cost of deposit capital is now rising rapidly, and deposits continue to lead the banking system with both consumers and businesses demanding much higher rates on their savings. But in addition, the regulatory capital charges for residential mortgages held at banks are about to rise as well. Where does the non-agency market go from here? Well, for many of these banks, continuing to offer competitive mortgage products to retain their clients will be imperative, and the solutions Redwood offers are a logical alternative to portfolio lending."

As for the BPL market, the firm noted volumes were down modestly sequentially, with fixed term originations down. The company is expecting the market to pick up in the second half.

At present, BPL bridge loans represent the bulk of RWT's portfolio, with about an 68% economic interest. Abut 90% of the loans are due within two years, with the other 10% due between 2-3 years. These loans are largely floating rate and thus shouldn't carry much interest rate risk.

Delinquencies, however, ticked up meaningfully quarter over quarter. Loans due past 90 days were 4.9% of the portfolio in Q2, up from only 2.1% of its portfolio in Q1. Historically, these loans have a delinquency rate of between 1.9%-6.2%. The geographical mix of the loans are pretty diversified, with Georgia and Texas the two largest states at 16% each.

How much book value declines will likely be what drives the stock when it reports earnings. However, investors should also keep a close eye on delinquency trends.

Valuation and Conclusion

When valuing mortgage REITs, I usually look at a price to book as the best way to value them. On that front, RWT trades at about 0.73x book. That's a nice discount. However, book value can change pretty quickly as evidenced by AGNC (AGNC) warning that its book value had fallen about -25% since the end of Q1.

Now there are some major differences between the two mortgage REITs. One is that the bulk of RWT's portfolio is in BPL loans, which shouldn't have the interest rate sensitivity that AGNC's portfolio has. Now RWT's investments in jumbo mortgages and other interest-rate sensitive investment will take a hit in mark-to-market value, but this makes up a smaller percentage of its portfolio.

RWT also carries much less leverage than traditional agency mortgage REITs. The firm has only 2.2x recourse leverage at the end of Q2, while AGNC had 7.2x. That additional leverage is going to exacerbate the mark-to-market declines in a portfolio.

What investors will need to watch with RWT that they don't have to with traditional agency REITs is delinquency rates. The firm saw a pretty big increase last quarter. Overall delinquency rates for multi-family properties remains low, but has started to tick up some. This is one of the big risks for RWT at this time given the current macro backdrop.

Overall, I'd expect RWT's book value to decline when it reports its results next week, but not nearly to the extent of agency mortgage REITs. Given its current large discount to book, I think the stock remains attractive, although I would wait until after earnings to be a new money buyer and also see how delinquencies are holding up. That said, I see no reason to change my longer term "Buy" rating at this point. The stock currently yields over 9.5%.