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Global Reit (2008)

Beth A. Di Santo, Partner at Di Santo LLP and REIT Lawyer, Moderator of "Specialty Finance REITs" at the Global REIT Symposium.

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Global Reit (2008)

  1. 1. Di Santo LLP www.reitlawyer.com<br />Global REIT Symposium<br />Specialty Finance REITs<br />BY: Beth A. Di Santo, Esq.<br />Di Santo LLP<br />
  2. 2. Di Santo LLP www.reitlawyer.com<br />Mortgage REITs<br />Characteristics:<br />No Direct Property Portfolio: <br />Unlike equity REITs that own and operate portfolios of real estate, mortgage REITs originate mortgage loans and invest in mortgage-backed securities. <br />Yield Spread:<br />Derives income from the spread between the yield on their mortgage-backed securities (MBS) and their cost of funding.<br />Yield spread: Borrow in the short-term and lend on the long-term<br />Wide spreads = more money<br />Small spreads (or negative spreads) = big problems<br />REIT Structure = No Retained Earnings<br />Given the requirement that mortgage REITs are obligated to pay out 90% percent of their taxable income in dividends means that growing the operations of a mortgage REIT is largely predicated on ongoing access to fresh capital in the equity markets or borrowed money.<br />Although some argue this exacerbated the impact of sub-prime meltdown, it is likely that retained cash would just have meant more borrowing by the REIT.<br />Historic Perspective:<br />Result: High dividends and increases in stock prices <br />2001 – 2004<br />2001: Short term rates were low and long term rates were high<br />2004: 12 residential mortgage REITs raised as much as $2.6 billion through follow-on public equity offerings in 2004.<br />2005: Federal Reserve began to increase short term rates flattening yield curve<br />2006: Yield curve inverted (i.e., short term rates were higher than long term rates)<br />2007: Yield spread remains very thin<br />
  3. 3. Di Santo LLP www.reitlawyer.com<br />Mortgage REITS<br />Impact of Market Fundamentals<br />Decline of the Index Fund<br />iShares FTSE NAREIT Mortgage REITs Index Fund (REM): Started trading around $50 on May 4, 2007.<br />20/20 Hind-Sight<br />Missed Opportunity: Mortgage REITs’ stock were trading at highs over the past few years, which was an opportunity to reduce bank credit by issuing unsecured corporate bonds.<br />Exposure to Housing Market Slump<br />Slowdown in housing market resulted in lower origination volume<br />Sub-Prime Meltdown<br />Correlation<br />Overly aggressive lending practices led to questionable loans, which were pooled and sold as bonds to investors in the capital markets.<br />Margin Calls: Mortgage REITs borrowed money based on the value of their loan portfolio. The value of the loans declined as borrowers defaulted on the loans. As a result, banks called for mortgage REITs to put up more money.<br />Short-Term vs. Long-Term Rates<br />Thin Yield Curve = continuing issue as Federal Reserve continues to lower short term rates<br />
  4. 4. Di Santo LLP www.reitlawyer.com<br />Mortgage REITs<br />Prospects<br />Short-Term<br />Wall Street will not support premium pricing for private mortgage securities, which will continue to reduce capital to Mortgage REITs<br />Margin calls: Need to find cash to fund margin calls<br />Case studies <br />Mortgage REITs with aggressive lending and investment strategies will fare the worst<br />New Century * American Home<br />Sell off mortgage portfolios at a loss to increase liquidity<br />Thornburg Mortgage<br />Long Term<br />Role of Private Equity and Hedge Funds<br />Private equity and hedge funds can provide cash for short-term financing needs.<br />Luminent Mortgage Capital, Inc. and Hanover<br />Disadvantages: Significant dilution to existing shareholders<br />Abandon Ship…Does the REIT structure make sense?<br />No interest from equity markets + payout of earnings = limited access to capital<br />Strategic mergers with financial institutions = lower cost of funds and access to fresh capital<br />Aames Investment Corporation merger with Accredited Home Lenders<br />MortgageIT merger with Deutsche Bank<br />
  5. 5. Di Santo LLP www.reitlawyer.com<br />Specialty Finance REITs<br />Distinguished from Mortgage REITS<br />Diverse Lending Practices:<br />Specialty Finance REITs (or SFR) do not exclusively lend money out for residential home purchases. <br />Like Business Development Companies (BDCs), SFRs can also invest up to 25% of their capital in direct private lending deals.<br />Private Equity Market: SFRs can participate in the private equity market with higher lending rates and equity kickers for future capital gains.<br />Professional Management of Investment Portfolios:<br />SFRs are able to adjust their portfolios rapidly to react to rising or declining interest rates. <br />SFRs contain the necessary flexibility to position their funds that benefit best from the prevailing trends in interest rates through the use of leverage and derivatives.<br />Actively Traded Portfolios:<br />SFRs generally build actively traded portfolios of structured notes backed by real estate assets (i.e., loan portfolios). <br />SFRs invest in notes that are investment grade as rated by Standard & Poors or Moody&apos;s Investment Service.<br />
  6. 6. Di Santo LLP www.reitlawyer.com<br />Specialty Finance REITs<br />Impact of Credit Crisis<br />Capital Markets: <br />Valuation of mortgage-backed securities declined with market uncertainty and widening of credit spreads<br />CDO issuances steeply declined thereby reducing funds available to lend<br />Lenders: <br />Cost of the secured borrowings used to operate SFR’s business increased as availability of credit is reduced<br />Margin reductions on borrowings = reduction of liquidity<br />unencumbered assets and cash used as additional collateral<br />less leverage available and at a higher cost = reduced earnings growth<br />
  7. 7. Di Santo LLP www.reitlawyer.com<br />Specialty Finance REITs<br />Portfolio Strategies<br />Procure additional funding sources<br />Private Equity, hedge funds, credit facilities, leverage unencumbered assets<br />Commercial Real Estate (CRE): <br />Market outlook in commercial real estate remains high. Focus the investment portfolio on CRE opportunities.<br />Invest in CMBS at wider yield spreads<br />Yield spreads tied to 10-year Treasuries have widened as a result of the sub-prime fallout.<br />Revisit RMBS sector if attractive yield spreads exist<br />Continue judicious use of CDO issuances to secure term financing<br />Pursue opportunistic investments from over-levered competitors<br />

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Beth A. Di Santo, Partner at Di Santo LLP and REIT Lawyer, Moderator of "Specialty Finance REITs" at the Global REIT Symposium.

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