As published in Scotsman Guide's Residential Edition, November 2005.
When mortgage bankers and brokers think of potential investors for their pipeline of jumbo, Alt-A and nonconforming loans, the usual candidates are thrifts, Wall Street firms, banks and insurance companies. Real estate investment trusts (REITs), on the other hand, do not usually spring to mind. They should.
Slowly but surely, these trusts are penetrating the mortgage market, and their impact is growing substantially.
A brief history
Until recently, REITs were passive investors in real estate related assets. Before 2001, REITs operated under a special provision in the Internal Revenue Service code. This provision allowed for corporate exclusion from income taxes if firms paid out at least 90 percent of their earnings as dividends to shareholders, with the qualification that the firms could only be passive investors in real estate related assets.
The early entrants into the industry primarily were investors in commercial real estate. Later entrants invested in commercial mortgage loans. It was not until the late 1980s that REITs were formed to invest in residential mortgage loans. Most of these invested in the residual interests of collateral mortgage obligations, and most were related to builders.
Eventually, REITs emerged that invested in whole-loan residential mortgages primarily originated by unaffiliated companies.
How they operate
Mortgage REITs have a similar risk profile to thrifts. Thrifts leverage their balance sheets by raising capital and then using that capital to raise deposits and borrow funds. REITs raise capital and then use it to borrow funds.
REITs are limited to the amount that they can leverage themselves, so most have a debt-to-capital ratio in the 10-to-1 to 12-to-1 range. Mortgage REITS have raised more than $10 billion in capital since 2001, so if a leverage ratio of 12 is applied, this means that at face value, REITs have $120 billion to invest in whole-loan mortgages.
This is not the whole story. When securitizing these whole loans, REITs will sell most of the cash flows and in some instances, will retain only 10 percent of the principal balance of a security. If we apply a 20-percent retention factor and a leverage ratio of 12, the potential investment power of the REIT industry can amount to as much as $600 billion.
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