Future of Mortgages, part 8: Rising Influence Of REITs

[Latest in our ‘Future of Mortgages’ series] A few years ago, REITs that bought and sold residential mortgage securities were very much off the radar screen. But times change and according to DealLogic, of the nine new REITs with IPOs planned this year, seven will invest in mortgage backed securities (often referred to on this site as mortgage bonds—which are the securities that consumer rates are derived from).

The value of the offerings totals $2.6 billion. According to Barclays, mortgage REITs that principally invest in mortgage-backed securities from Fannie Mae, Freddie Mac, and Ginnie Mae have raised at least $6.6 billion in equity since December, and these cater to investors who want to buy into these kinds of investment vehicles who don’t have access to a large bond fund because the minimum investments are very high. But why are they hot now?

Analysts say that the interest reflects perceptions that prices for current securities, which have been rising in recent months from the distressed levels reached during the financial crisis, will continue to move higher in the years ahead.

In addition, interest rates set on new mortgages in the future are expected to be higher than current levels, whether due to the overall economic climate pushing rates higher (not right now) or Freddie & Fannie’s role being reduced and private banks increasing their share (more likely).

Size of REITs & Role In Mortgage Market
The total market capitalization, or the aggregate value of REITs could be as high as $42 billion and growing, according to an estimate from investment bank Keefe, Bruyette & Woods (versus $500 million in 1971 and $30 billion by the end of 2010).

REITs have special tax exemptions and an ability to hold more capital under upcoming lender risk-retention rules.

So why are REIT’s buying? This is a key reason that spreads remain range-bound despite the news of the Treasury unwinding its MBS portfolio, and the leverage opportunities are very attractive.

Analysts believe that more growth could come as the mortgage market becomes dependent on more capital. Currently, $1.5 trillion in mortgages and MBS sit on Fannie Mae and Freddie Mac balance sheets with another $1 trillion in MBS at the Federal Reserve.

Assuming a run-off rate of 10% per year replaced by private capital, the mortgage market could need roughly $110 billion in private capital in the next decade which could double the current $42 billion that REIT’s control.

This is why mortgage REITs are important.

Rules For REITs
Larger lenders seem to have some interest in forming REITs, which isn’t exactly easy.

REIT’s are required to pay at least 90% of their taxable income out as dividends (a drawback for some owners), and in recent years these dividends have been higher than other financial stocks and U.S. Treasury securities.

Dividend yields on residential-mortgage REITs have been especially large, averaging over 14% compared with 3.5% for all REIT’s.

Mortgage REITs have high dividend yields partly because the managers use high leverage, which can boost returns.

The REITs use low-rate, short-term debt to finance their bond purchases.

Also, a REIT must be an entity that is taxable as a corporation and be managed by a board of directors or trustees.

It must have shares that are fully transferable and have a minimum of 100 shareholders.

No more than 50% of its shares should be held by five or fewer individuals during the last half of the taxable year.

A REIT must invest at least 75% of its total assets in real estate assets and derive at least 75% of its gross income from rents, from real property or interest on mortgages financing real property.

It should have no more than 25% of its assets consist of stock in taxable REIT subsidiaries.

Due to the high payout ratio, REITs routinely issue secondary offerings because they are unable to increase their capital base using retained earnings.

And a mortgage REIT must invest at least 55% of its assets in “qualifying interests.” To meet this test, an agency mortgage REIT invests 55% of its assets in whole pools. That is, pools with undivided interest in a mortgage.