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   ARTICLE   |   From Scotsman Guide Residential Edition   |   November 2005

The New Whole-Loan Investors

Real estate investment trusts offer advantages to brokers and customers

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.

Legal developments

The REIT Modernization Act, which took effect in 2001, allows REITs to own and operate taxable REIT subsidiaries (TRS). This was designed to help commercial-property-oriented REITs acquire affiliated businesses such as cafeteria operators and janitorial-service providers. Instead, passive mortgage REITs began acquiring mortgage-origination capacity, and some mortgage bankers converted to REIT status.

Why did this happen? REITs enjoy a significantly higher yield on self-originated mortgage loans than they do on alternative investments. Consequently, there is a financial imperative to increase origination capacity. At the same time, the investing public encourages the acquisition of active originating subsidiaries because they are perceived as increasing the dividend yield and ultimately, the stock price.

If a TRS generates a loan for the REIT portfolio, it cannot book a gain on sale. If an REIT only generated portfolio loans, the TRS would always operate at a loss in the current period because it can only defer the direct costs of origination and would incur the indirect costs.

To generate earnings, most REITS offer a broader product mix that enables the generation of gain on sale income for loans targeting the secondary market. TRS earnings are taxed as a normal corporation. Because there is no requirement to distribute TRS earnings to shareholders, most REITS retain these earnings to increase book value for the corporation as a whole.

Advantages for investors

Mortgage REITS traditionally provide a high dividend yield for their investors. These yields range from 10 percent on the low end for REITs that only invest in high-quality mortgage loans to as much as 18 percent on REITs that invest only in nonprime.

Most REITs fund portfolios with short-term borrowings that are usually tied to the London Interbank Offered Rate. Most REITs, therefore, typically invest only in adjustable-rate-mortgage loans to maintain an acceptable duration gap between the repricing of the assets and the liabilities. Investors typically want to see less than a year in the duration gap. Without this, the REIT will trade at a higher dividend yield than its peers.

The benefit to customers

A REIT is a true portfolio lender. As opposed to their mortgage-banking competitors, who must sell every loan they originate, REITs can use discretion and take loans into their portfolio that are good credit risks but that might not fit secondary market guidelines. This means that when dealing with a REIT, mortgage brokers and their account executives can preview loans that do not fit published guidelines and possibly get a pre-approved exception.

The creation of the mortgage-REIT industry and the implementation of the REIT Modernization Act added a new dynamic to the mortgage market. As a result of the act, new competitors to traditional mortgage banks have emerged on the scene.

The new investors in mortgage assets are heavily capitalized and have portfolio power. Unlike mortgage banks, REITs can consider loans from an investment standpoint, so it is to every broker’s advantage to get approved to originate for these new mortgage investors. This will bring the power of the portfolio to the mortgage brokers. It also will allow them to close loans that they would have been unable to close in the past because they did not meet secondary guidelines.

In today’s market, where the role of REITs is growing steadily, the name of the game is flexibility. And that’s good news for investors, lenders, brokers and their customers — you can bank on it.


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