This year has been miserable for the real estate industry, especially for anyone involved in the mortgage market. Mortgage originators have struggled with declining volumes, while the mortgage real estate investment trusts (REIT) have dealt with underperformance of their most significant asset -- mortgage-backed securities (MBS). Many of these mortgage REITs have eye-popping dividend yields, but investors should be careful assuming these yields will hold up. Two Harbors (TWO -0.51%) has a high-teens dividend yield, but should investors bank on it continuing?
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Mortgage REITs are a different animal
Mortgage REITs are different from the typical REIT, which generally follows a landlord/tenant model. These companies develop properties such as office buildings, apartments, or shopping malls and then lease them to tenants. Mortgage REITs don't buy individual properties; they invest in real estate debt. They buy mortgage-backed securities and collect interest. In this way, they are more similar to a bank or a hedge fund.
As the Federal Reserve began raising rates in earnest this year to combat inflation, mortgage-backed securities lost value because of the inverse relationship between fixed-income securities and interest rates. More critically for Two Harbors, mortgage-backed securities lost value compared to comparable maturity Treasury bonds. In trader parlance, mortgage-backed security spreads "widened." In the third-quarter earnings press release, Bill Greenberg, Two Harbors president and chief executive officer, said that "mortgage spreads widened to levels not seen except in crisis periods."
MBS spreads are "widening"
The net impact of spread widening is that mortgage-backed securities underperform their hedges, which are designed to limit losses from adverse changes in interest rates. The result was that the value of Two Harbors's assets fell at a faster rate than Treasuries, and the hedges didn't make enough money to offset the losses. This widening is the reason for Two Harbors' reported 20% decline in book value during the quarter from $20.41 at the end of June to $16.42 at the end of September.
For the most part, widening spreads are a paper loss, not a realized one, though Two Harbors did sell some of its portfolio to buy back preferred shares at a discount. These wider spreads should, however, represent future earnings as MBS spreads return to normalcy.
Can earnings keep up with the dividend?
At current levels, Two Harbors has a dividend yield of 16.3%, which is a highly attractive dividend yield. The big question is whether that dividend yield is sustainable. Two Harbors tracks a metric called "earnings available for distribution," which represents cash earnings that can be used to pay the dividend. In 2022's Q2, earnings available for distribution came in at $0.87 a share, which was enough to support the $0.68 quarterly dividend. In the most recent quarter, earnings available for distribution came in at $0.64, which is below the $0.68 dividend.
If earnings available for distribution recover back to something like $0.87 per share, then the dividend probably is sustainable. If mortgage-backed security spreads begin to revert back to the mean, then book value should increase (basically reversing the declines we have seen this year), and Two Harbors will probably maintain the dividend. As a side note, it is important to point out that earnings available for distribution is not an accounting term that complies with generally accepted accounting principles (GAAP). It is a calculation that is made internally.
On the earnings conference call, the company mentioned that earnings available for distribution were expected to moderate over the coming few quarters. This could put pressure on the company to maintain its dividend. In its earnings presentation, Two Harbors said it expected the "static return" on its portfolio to be somewhere around 13% to 16.8%. Based on the current book value per share of $16.42, this means anywhere from $2.13 per share to $2.76 per share. The current annual dividend is $2.72 per share, so Two Harbors doesn't have margin for error.
Signs of moderating increases in inflation caused a big rally in the stocks and bond markets in recent days, and mortgage-related names were all up in sympathy. A return to normal volatility in the stock and bond market would go a long way toward supporting future earnings for the mortgage REITs. For investors in Two Harbors, the dividend looks sustainable if everything goes the company's way. There also is a risk they won't, increasing the odds of a dividend cut. Investors should not take that 16% dividend yield as a sure thing.
