Should You Move in on New Mortgage REITs?

There's been an obvious increase in mortgage REIT activity in 2009. What are some of the factors driving this trend?
While there are a number of factors behind the recent spate of mortgage REIT IPOs, it basically boils down to managers taking advantage of the current favorable environment for the REIT business model. Like any financial company, mortgage REITs make money from the spread between the cost of their financing and the yield on their investments. The greater the spread, the more money they make, and the current spread is as wide as it has been in years.

Mortgage REITs not only use equity capital, like the cash proceeds from an IPO, to purchase assets, but they also need to lever up with debt financing to generate adequate returns for shareholders. Generally, mortgage REITs use short-term (60- to 90-day) financing like reverse repurchase agreements to invest in longer-term assets. Right now, all manner of government efforts are keeping short-term rates low in comparison to long-term rates, and mortgage REITs are benefiting from the steep yield curve. The availability of special financing vehicles like the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF) and the U.S. Treasury's Public-Private Investment Program (PPIP) also plays into the timing of the REIT filings, as these sources of financing are potentially more stable and lucrative, which helps in drawing in potential investors.

On the asset side of the balance sheet, the mortgage REITs are seeking to exploit a buyer's market for residential and commercial mortgage-backed securities (RMBS and CMBS) and distressed loans and properties, as the illiquid markets for these investments depress prices. Purchases of these "toxic" assets at prices below fair value would give the REITs high yields as well as the opportunity for capital appreciation. Additionally, hundreds of billions of dollars worth of commercial mortgages will be in need of refinancing over the next few years, and since there is little enthusiasm from traditional lending sources like banks and life insurers to roll these loans over, mortgage REITs have an opportunity to fill the gap and make loans at attractive yields and with good terms.

Some of these recent offerings have been successful, but a few have raised only half the money that was originally sought, while others have been postponed all together. Why is this happening?
Essentially, the timing of the offering determined its success; the first to go to market met investor demand, leaving the "me-too" offerings that came later fighting over the scraps of remaining investor interest. Companies that were already in operation like Cypress Sharpridge Investments were able to quickly drum up investor interest, and were among the first to seek funds in June when the IPO market reopened. Then in August, Starwood Property Trust was able to raise 38% more than it had initially sought as investors were comforted by the backing of well-known real estate investor Barry Sternlich. But by September, the remaining REITs wishing to access IPO funds were largely met with investor indifference as there was little to distinguish them from one another. Investors are more interested in secondary offerings from existing REITs than IPOs of companies with no operating history or assets. It's difficult to justify buying into a newly formed entity with an uncertain dividend yield when you can purchase a mortgage REIT like  Annaly Capital with a solid long-term track record and a dividend yield of 15%.

It appears that someone is getting rich off these deals; who are the bottom-line beneficiaries?
Each of these proposed mortgage REITs is the offspring of an existing management company, and the structure of the REITs favors the officers of these firms. Since the REITs are currently just empty shells, they have all agreed to outsource their management to a newly created affiliate of the existing sponsor, whose employees will run the REIT. Of course, this arrangement comes with a fee, generally 1.50% of shareholders' equity payable quarterly. In many cases, the outside manager is also entitled to an incentive fee, often along the lines of 20% of annual earnings over and above a hurdle rate of 8% of the firm's initial market value. This fee structure skews the incentives in favor of management, as the managers get guaranteed pay as well as a stake in the upside, but shareholders are left holding the bag on their own if the REIT endures large losses. While this is a very good deal for the managers, it could also explain why investors are beginning to shun some of these offerings.

Will we continue to see an active market for mortgage REIT filings, and what would cause filing activity to increase/decrease?
There will be interest in mortgage REITs as long as the dividend yields remain attractive. If the companies that have successfully executed their IPOs continue to perform well, it should whet investor appetite for more offerings. While we're confident that this ideal operating environment can't last forever, as interest rates will eventually go up, it could be quite a while before this scenario comes to pass.

On the other hand, commercial occupancy and rental rates are still dropping in nearly every part of the U.S., leading to climbing commercial loan delinquencies. The concern is that these delinquencies are not factored into current CMBS pricing. In the face of this risk, investors may pause before stepping up to the next mortgage REIT IPO.

We've disliked a lot of these offerings. What kind of deal metrics would it take for us to support one?
One of the big problems standing in the way of our support for one of these deals is the high correlation between equity prices and real estate prices currently. No one wants to go public when the equity market is in the doldrums, even if that's when the best real estate deals are available. When the equity markets are performing well and there is interest from both buyers and sellers for a REIT, the opportunity for managers to put the funds to work is not as great. That's why we are more interested in mortgage REITs with existing operations looking to go public than in newly formed entities with no legacy assets.

This report is made available compliments of Morningstar IPO Research Services. For more information on Morningstar IPO Research, please contact Marc DeMoss at marc.demoss@morningstar.com or +1 312 384-4052.