There's just no one else

Simon Crompton

Managing editor

"In the midst of the financial crisis, one would never have believed that a mortgage investment vehicle, least of all one with the chequered history of Reits, would become popular in 2009. But lo and behold, it is," said Tom Humphreys, partner at Morrison & Foerster, at last month's IFLR web seminar. There have been at least 14 filings for new mortgage real estate investment trusts (Reits) this year, and over the summer several floated, raising over $2 billion.

One reason Reits have been so popular is the illiquidity of other means to invest in real estate. "They give investors real access. Even if you don't like the price you can generally find your way out," said Halle Bennet at UBS. "I think that's a huge positive and will be a drive of future Reit origination."

Bennet also pointed out the quality of sponsors behind Reits. Colony Capital and Apollo Capital, "some of the best names in distressed and real estate investing," have been accessing the public Reit market. "That shows that this product is here to stay and why people are investing, despite the problems of the market as a whole," he added.

Those Reits fall into three main strategies – investing in high-quality securities using leverage, originating mortgage loans and then securitising them, and investing in distressed debt. A successful example of the first is Annaly Capital Management, which has bought into government-guaranteed mortgages with leverage – and performed well throughout the crisis.

But distressed debt is the biggest driver at the moment. "It's an exciting time for people to buy into distressed assets," said Bennet. "Whether that will last is a big question. There have been a lot of failures since the eighties, not due to credit but due to leverage – most of the big commercial mortgage flotations of five years ago are just shells now. The difference today is that the Reits are taking the place of Wall Street and the community banks. They can't lend so Reits are stepping in, and that means they'll be around for a while."

One unique transaction was that signed between Colony Capital and homebuilder William Lyon recently. Colony bought several empty lots (at a very low price), willing to accept the cost of carrying those lots until houses could be built and sold off. This is large-scale, long-term distressed investment.

Recent REIT IPOs
IPO date	Issuer	Manager	Completed IPO size ($mm)	Gross proceeds ($mm)1	Asset class focus	Incentive fee?
9/23/09	Apollo Commercial Real Estate Finance	Apollo Global Management	200	210	Commercial loans	No
9/23/09	Colony Financial Inc	Colony Capital	250	293	Commercial loans	Yes
9/16/09	CreXus Investment Corp	FIDAC (Annaly)	200	268	Commercial loans	No
8/11/09	810	952	Commercial loans	Starwood Capital Group	Starwood Property Trust Inc	Yes
7/29/09	PennyMac Mortgage Investment Trust	PNMAC Capital Management (BlackRock, Highfields)	320	335	Residential - distressed loans	Yes
6/25/09	Invesco Mortgage Capital Inc	Invesco Ltd (NYSE: IVZ)	170	206	Diversified - PPIP	No
6/11/09	Cypress Sharpridge	Cypress Sharpridge Advisors LLC	100	115	Residential - Agency MBS	No
Note: 1 Gross proceeds including over-allotment option and private placement Source: Company Filingst

As well as strategy, the Reits divide into those managed internally and externally. Internal managers sit within the Reit and are compensated on a traditional corporate structure – salary, bonuses, stock options – and external managers are usually part of a broader asset management firm, paid on a fees basis and often sponsored by a financial institution or private equity firm.

Annaly's assets are managed by Fidac, a wholly-owned subsidiary that also manages the recently floated Crexus on the commercial mortgage side (Annaly being largely residential mortgages). "They've been able to very successfully integrate the assets and external management," said Halle Bennet. "In fact Annaly, with market cap of around $9 billion, is today the largest market-value mortgage finance company in the US. That's staggering and rather sobering. They've been able to raise a lot of capital relative to their asset value. And as new deals have become successful, investors are demanding new structures and closer alignment of interests."

This is one of the key legal issues. External managers of Reits usually receive a base fee relating to either assets or equity value and then an incentive fee linked to certain hurdles, typically around eight to 10%. But there has been more experimentation with these structures recently, with some more linked to equity (an example being Colony Capital) to try and align interests with shareholders.

Among other legal issues, an existing company can re-organise itself as a Reit or be founded as a Reit; the key is to keep any assets that yield non-qualifying income out of the structure. In the US Reits are normally organised in Delaware or Maryland – both have a body of law that is specific to Reits but Maryland has probably the best-formed legislation and has gone to great efforts to attract new Reits. There are important differences between the two – Delaware, for example, requires one trustee of the Reit to be resident in the state, but Maryland does not. Maryland also expressly limits the liability of Reit trustees, allowing more expansive indemnification provisions.

"That's a very compelling thing to consider when advising a client on where to establish its Reit," commented Anna Pinedo, partner at Morrison & Foerster.

Then there's the question of how a Reit is structured. There are UpReits, DownReits and several others – including paired or stapled Reits. UpReit stands for umbrella partnership Reit, and under it the Reit doesn't own any interest directly in the property or securities. Instead it owns a stake in an intermediary entity, the operating partnership. Several limited partners then put property into that operating partnership, and receive units in the Reit in return (representing one share each). Importantly, that contribution is not subject to federal income tax; Reit shares themselves would have been taxable.

"This structure was very popular in the nineties, largely driven by result of investors in real estate tax shelters looking for an exit," said Tom Humphreys, tax partner at Morrison & Foerster. "It bailed out hundreds of groups of real estate investors."

This year there have been several mortgage UpReits. But the driver is acquisitions rather than transferring existing assets. When a Reit wants to buy up a mortgage portfolio, it can give the sellers a stake in the operating partnership of the UpReit rather than cash, making any gain non-taxable.

A DownReit shares the tax advantages of an UpReit, but uses property that is already within a Reit structure. It has largely been used by existing Reits that want to gain the acquisition advantages of an UpReit. So they give property 'down' from their Reit into an operating partnership that can make the same type of acquisitions.

A paired-share Reit is the most flexible structure, allowing investment in real estate as well as operational management of assets. These have been less popular since the nineties, as the physical pairing of shares is no longer possible under the US Internal Revenue Code – though some newer structures do try to emulate them.

"UpReits are the most populous structure out there now," said Pinedo. "Though DownReits have been popular recently."

Mortgage UpReit

To hear the web seminar in full, go to www.iflr.com/webseminars

What is a mortgage Reit?

A Reit is any vehicle that is designed for investors to pool capital to invest in real estate assets, provided that it meets certain tax requirements. They are usually publicly traded, which adds greater liquidity and allows investors to exit at any time. For US tax purposes they are a pass-through entity, meaning that there is no tax at the entity level. And the Reits pay dividends. There are several types of Reits – equity, mortgage and hybrid. Equity Reits directly invest in property and draw investment from the rents; mortage Reits investing principally in mortgage securities; and hybrids are a mix. The capital structure of a Reit can involve common and preferred equity, senior and subordinated debt. So it is very flexible. And the Reit can be managed internally or externally, by employees of the Reit or by a third party. That third party is controlled by a management contract that is rather like the advisory agreement for an investment bank. Mortage Reits have a lot of history. "This isn't the first surge in mortgage Reits we've seen and it probably won't be the last. Over the years we've seen them become popular and then unfortunately they run into problems," said Tom Humphreys of Morrison & Foerster. Reits are very efficient ways to invest in real estate and even mortgage Reits date back to the late seventies. But they also operate on leverage, which has made them risky investments. While the permanent capital of shareholders gives them stability, the leverage is temporary and depends on Wall Street. The first Reits were construction loan Reits formed by several banks in the sixties and seventies. They collapsed when the real estate market went into a downturn and developers couldn't repay their loans, the most famous failure being one Reit sponsored by Chase Manhattan Bank. That soured the acronym for years. "I did my first Reit offering in 1982 and the word was so poisoned that it didn't appear in the prospectus until the tax section, where we finally had to tell people that it was an R-E-I-T," remembers Humphreys. The eighties saw a different type of Reit, designed to make residential loans that were so big they couldn't be covered by the government entities. They sold 90% of the senior interest in the loan, kept 10% and then did the structure again. Famous names were Strategic Mortgage Investments, Countrywide and Capstead. By the mid-eighties, mortgage Reits had shifted to originating loans and selling collateralised mortgage obligations. They became part of a securitisation pipeline. Mortgage Reits took off in the nineties, both jumbo and sub-prime. And by the early 2000s, many were involved in sub-prime, which led to the spectacular collapse of American Home Mortgage Investment, New Century Financial and People's Choice Financial amongst others.