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Rhythm Capital Corp. (NYSE: RTM), formerly known as New Residential Investment Corporation, is currently trading at a yield of over 11%. This raises the question of whether an investment in Rithm Capital is a yield trap.

Even if the the trust’s 11% yield is impressive, Rithm Capital is not your typical mortgage real estate investment trust (“mREIT”) with a huge portfolio of mortgage-backed assets.

Rithm Capital, on the other hand, is a non-traditional trust with significant assets in residential loans, real estate securities and mortgage servicing rights.

In a rising rate market, mortgage servicing rights provide Rithm Capital with revenue potential.

Rithm Capital’s 11% dividend yield is neither a red signal nor a yield trap as it is also covered by earnings available for distribution.

Potential for higher distributable earnings

Rithm Capital is not your ordinary mortgage trust. Rithm Capital invests in leveraged mortgage and real estate assets, although these assets are fundamentally separate from those of mortgage real estate investment trusts such as Annaly Capital Management, Inc. (NLY).

Rithm Capital invests in a wide range of mortgage assets, including agency and non-agency residential mortgage-backed securities, single-family residential loans and so-called mortgage servicing rights.

The right to service a mortgage (an MSR) gains value for managers as interest rates rise, which they will do significantly in 2022. Mortgage service rights become more valuable as interest rates rise, implying that the trust sees higher MSR values/income during periods of rising interest rates. Higher interest rates are a clear path to higher distributable profits for Rithm Capital.

Portfolio overview

Portfolio Snapshot (Rithm Capital Corp)

Mortgage servicing rights are just one way for the trust to generate more distributable profits in the future. Another option to generate greater income in the near future is the internationalization of the management of the trust.

Rithm Capital has recently internalized its management, which means that the trust will no longer have to pay incentive fees to its former internal manager. The economic impact of insourcing has been estimated at $60-65 million per year, or $0.12-0.13 per share.

For Rithm Capital and its shareholders, this means that more of the profits will be available for distribution, which could translate into a larger dividend.

Estimated annual net economic benefits

Estimated annual net economic benefits (Rithm Capital Corp)

Excessive 27% discount on book value for no reason

I mentioned Rithm Capital’s low payout ratio based on distributable earnings in my previous article. It was 81% in 2Q-22 and 66% in the previous twelve months, indicating that the dividend is not only secure but also has the ability to increase.

Also, the low valuation of the Mortgage Trust does not sufficiently reflect the low payout ratio, for which I see no justification.

The discount to book value recently increased to 27%, which I believe is not warranted given the trust’s low payout ratio.

Chart
Data by Y-Charts

Why Rithm Capital could see a lower valuation

Rithm Capital, in my view, is significantly undervalued, due to the exorbitant discount to book value and the fact that the mortgage trust is well positioned to weather rising interest rates.

Additionally, Rithm Capital has a proven ability to cover its dividend with distributable earnings, and the payout ratio is relatively low for a mortgage trust with a double-digit dividend yield.

However, there are risks to Rithm Capital that could lead to lower book values, including higher loan losses, lower economic potential realized through insourcing, and lower cyclical interest rates, which would overrule my favorable comments on the trust’s mortgage servicing rights. wallet.

My conclusion

I’m loading the truck with Rithm Capital’s 11.2% dividend yield right now because it not only looks safe, it looks really safe.

The trust’s payout ratio based on distributable earnings was 66% in the second quarter, which leaves plenty of room for long-term dividend growth. The low payout ratio is truly unique and sets Rithm Capital apart from other mortgage real estate investment trusts I have reviewed.

The very steep and unjustifiable discount to book value that has recently widened, in my view, significantly enhances Rithm Capital’s value case. Rithm Capital stock is a solid buy in my opinion.