BofA/Merrill Lynch - Why New Residential Investment (NRZ) Has 20% Upside Potential

On April 20, BofA/Merrill Lynch (BAML) published a report initiating coverage on New Residential Investment Corp (NYSE: NRZ), a REIT which is focused on mortgage servicing rights (MSRs).The company was formed as a subsidiary of Newcastle Investment Corp (NYSE: NCT) in September 2011 and was spun off as an independent company in May 2013; externally managed by an affiliate of Fortress Investment Group (NYSE: FIG).Earlier in April, New Residential acquired the MSR assets from Home Loan Servicing Solutions (NYSE: HLSS), part of the beleaguered Ocwen Financial (NYSE: OCN) family of companies.Notably, while Ocwen was retained for two years as the named mortgage servicer on these assets, NRZ now has the call rights on the underlying mortgages.Tale Of The Tape - Past YearBAML believes that the new HLSS/OCN relationship was a "game-changer… as it allows NRZ to expand its servicer relationship beyond affiliate Nationstar," also a non-bank servicer of mortgages -- primarily non-performing loans (NPLs) similar to Ocwen.BAML - New Residential Investment: Initiated Buy, $18.50 Price Objective (PO) BAML views NRZ as having ~20 percent upside potential from both price appreciation of 10.6 percent, as well as a 2016E distribution of $1.66 per share, currently ~9 percent. Notably, BAML views the HLSS acquisition as being "immediately accretive" to earnings and BAML forecasts an 18 percent quarterly dividend increase from $0.37 to $0.45 per share. BAML thinks "the market will likely value NRZ at a premium to residential mortgage REITs, which yield around 11% currently, and at a discount to commercial mortgage REITs, currently yielding 8%."BAML - Mortgage Servicing OverviewNon-bank servicers have grown market share, as commercial banks look to avoid the regulatory complications that come from mortgage servicing -- especially servicing (NPLs).The recent well-documented regulatory problems of the Ocwen Financial/Altisource family of companies has resulted in this previously unanticipated growth opportunity for NRZ.Similar Yet Slightly Different Business Models BAML noted, "Prior to the HLSS transaction, NRZ owned excess mortgage servicing rights. HLSS primarily invested in Rights to MSRs. NRZ also invests in servicer advances under which NRZ receives a portion of the base servicing fee." HLSS' rights to MSRs will be split between excess servicing and servicer advances by NRZ for clarification and accounting consistency. BAML - NRZ Investment Rationale Stable dividend income: "NRZ is structured to produce earnings across of a range of operating and economic backdrops, which should lead to stable dividend income for investors."  High quality asset base: "NRZ assets consist primarily of excess MSRs and servicer advances that hold a senior position in the underlying mortgage cash flows and thus have limited credit risk."  Key Customers: "NRZ historically has had a preferential relationship with Nationstar. The acquisition of HLSS' assets extends the network to include Ocwen. Being embedded with the two largest non-bank servicers is an advantage."  Rising Rates Benign: "Servicing related assets are unique among financial assets in that they generally increase in value as interest rates increase. This is due to the inverse impact of interest rates on prepayment speeds, which results in extending the life of mortgages and the associated servicing fee stream."BAML - Risks To NRZ PO 1. The New Residential Investment business model is dependent upon the performance of third-parties such as Nationstar and Ocwen.2. Prepayments of underlying mortgages could reduce earnings from MSR's.3. Regulatory risks could affect both the business environment and investor perceptions of NRZ.4. Re-investment risks resulting from an inability to replace or grow MSR business lost to prepayment or mortgage pay-offs.Investor TakeawayInvestors considering investments in residential mREITs, or mREITs which make loans primarily associated with commercial real estate, have another asset class to consider which could act as a hedge in a rising rate environment.However, the regulatory risks associated with MSR's on non-performing loans, and a relatively complicated business structure, could become challenges for NRZ investors moving forward.