Mortgage REIT’s Are Aloft, but Dangers Remain
By VIVIAN MARINO at New York Times
SOME investors who are new to the market of real estate investment trusts may not know that a small percentage of REIT’s don’t own any real estate. Instead, these companies hold the mortgage debt used to finance property or lend money themselves to owners and developers.
It may not be hard to understand why mortgage REIT’s have been overlooked: not only is their business structure generally more complicated, but they performed dismally last year as short-term interest rates crept up.
But some industry analysts say they think that they deserve another look — especially those REIT’s that focus on the residential mortgage market.
The residential mortgage REIT sector, which had a negative return of nearly 26 percent, on average, in 2005, yielded a handsome 13.6 percent this year through Thursday, according to the National Association of Real Estate Investment Trusts. That is higher than the average return of 8.0 percent for commercial mortgage REIT’s, the association said, and not too far behind the 15.02 percent average return on equity REIT’s, the much larger market that holds property.
And now, with the Federal Reserve perhaps near the end of its increases in short-term interest rates, some analysts think that residential-mortgage REIT’s may have turned the corner. Rising rates, after all, were disastrous for REIT’s that borrow in order to invest in various mortgage loans, a hedging technique that is part of some companies’ business strategy.
So, should investors now stock up on residential mortgage REIT’s while share prices are still relatively cheap? Could they someday even see a rerun of 2003, when returns averaged a sizzling 42.7 percent?
Paul Miller Jr., a managing director at the Friedman, Billings, Ramsey Group, for one, says he thinks that now may be “a good time to buy” certain shares. He says business fundamentals are improving over all and that the prices of many mortgage REIT’s still have room to grow. “It’s a stock picker’s market,” he added.
Other analysts, though, are worried that a softening housing market will reduce loan originations and that a larger number of adjustable-rate and interest-only mortgages will expose some lenders, including REIT’s that originate mortgages, to more defaults.
“It’s a challenging time, even if the Fed is done,” said James Ackor, an analyst at RBC Capital Markets, “because it’s not entirely clear what kind of damage has been done as a consequence of the Fed activity.”
What many in the industry do know is that the mortgage REIT sector was hit by a triple whammy: higher short-term rates, along with, oddly, falling long-term rates, and a continuing wave of mortgage prepayments from refinancing. Of course, some mortgage REIT’s fared better than others. There are 33 in all; 22 focus on residential mortgages and the remainder on commercial, according to the national REIT association.
On the residential side, diverse business models and investment strategies mean that each REIT “has to be looked at separately when determining the impact of changing rates on their performance,” explained John J. Kriz, a managing director for real estate finance at Moody’s Investors Service.
Some residential mortgage REIT’s, like the American Home Mortgage Investment Corporation, the HomeBanc Corporation and New York Mortgage Trust, own subsidiaries that originate home loans. These “active” REIT’s have generally done better in an environment of rising interest rates than “passive” REIT’s like Annaly Mortgage Management and Luminent Mortgage Capital, which buy mortgage securities, analysts say. Other REIT’s, like the Thornburg Mortgage Asset Corporation, have both active and passive investment strategies.
The passive REIT’s were especially hurt by the flattened yield curve as short-term rates rose faster than long-term ones. No longer were they able to borrow at low short-term rates, then turn around and invest that money at higher rates in longer-term securities, a strategy that had yielded rich profits before the Fed began tightening its credit policies to stave off inflation.
As a result, some mortgage REIT’s have had second thoughts about sticking with the REIT business structure, which requires them to disburse at least 90 percent of their earnings as dividends in exchange for tax benefits. Many investment funds originally converted to REIT status because of the success of REIT’s in attracting capital.
“When things get rough, we see a tendency to de-REIT,” Mr. Miller said, explaining that if a fund gives up its REIT status, it can retain more of its earnings and seek other ways to raise revenue.
Analysts are also expecting some REIT companies to exit the residential mortgage business or to merge with other companies. This month, MortgageIT Holdings, a mortgage originator, announced that it had agreed to be acquired by Deutsche Bank for around $429 million. Another REIT, the Aames Investment Corporation, which lends money in the subprime market — borrowers with weak or impaired credit — agreed last spring to be acquired by Accredited Home Lenders for $340 million.
Although the business environment remains challenging for home mortgage REIT’s as questions remain about the direction of interest rates, many analysts advise investors to stick with the more established REIT’s in the home mortgage sector.
Mr. Ackor says he likes American Home Mortgage, a mortgage originator, which recently raised its dividend to 96 cents a share from 91 cents and has reported a higher-than-expected number of mortgage originations.
“American Home has done a very good job over the course of the last few years, although it’s not the cheapest stock,” compared with other mortgage REIT’s, he said. Shares are trading at less than $35, though Mr. Ackor thinks they could go as high as $40.
He says he also sees future improvement for other mortgage originators like HomeBanc and New York Mortgage Trust.
Matthew Howlett, an analyst at the investment bank Fox-Pitt, Kelton, favors Redwood Trust, a passive home mortgage REIT, which he says has an “efficient operating platform and strong management team.” He was also positive about New Century Financial, one of the nation’s largest providers of subprime mortgage loans, which announced that its total loan production for May was $5.5 billion, an increase of 28 percent over May 2005.
An expanding subprime market, of course, means more opportunities for mortgage REIT’s, which, according to Jason Willey, an analyst at Standard & Poor’s, can certainly use the business. “We believe there is an increasing amount of capital chasing a smaller amount of opportunities,” Mr. Willey said in a report released last month. And, he said, this means that some REIT’s have been “forced to accept smaller returns, or take on greater risk, in order to secure business.”
Mr. Willey, like many others, says he believes that the sector’s fate is riding on the Fed as well as the overall health of the economy, particularly job growth — or at least the market’s perception of both.
Mr. Ackor said, “There’s a lot of psychology involved.”
SOME investors who are new to the market of real estate investment trusts may not know that a small percentage of REIT’s don’t own any real estate. Instead, these companies hold the mortgage debt used to finance property or lend money themselves to owners and developers.
It may not be hard to understand why mortgage REIT’s have been overlooked: not only is their business structure generally more complicated, but they performed dismally last year as short-term interest rates crept up.
But some industry analysts say they think that they deserve another look — especially those REIT’s that focus on the residential mortgage market.
The residential mortgage REIT sector, which had a negative return of nearly 26 percent, on average, in 2005, yielded a handsome 13.6 percent this year through Thursday, according to the National Association of Real Estate Investment Trusts. That is higher than the average return of 8.0 percent for commercial mortgage REIT’s, the association said, and not too far behind the 15.02 percent average return on equity REIT’s, the much larger market that holds property.
And now, with the Federal Reserve perhaps near the end of its increases in short-term interest rates, some analysts think that residential-mortgage REIT’s may have turned the corner. Rising rates, after all, were disastrous for REIT’s that borrow in order to invest in various mortgage loans, a hedging technique that is part of some companies’ business strategy.
So, should investors now stock up on residential mortgage REIT’s while share prices are still relatively cheap? Could they someday even see a rerun of 2003, when returns averaged a sizzling 42.7 percent?
Paul Miller Jr., a managing director at the Friedman, Billings, Ramsey Group, for one, says he thinks that now may be “a good time to buy” certain shares. He says business fundamentals are improving over all and that the prices of many mortgage REIT’s still have room to grow. “It’s a stock picker’s market,” he added.
Other analysts, though, are worried that a softening housing market will reduce loan originations and that a larger number of adjustable-rate and interest-only mortgages will expose some lenders, including REIT’s that originate mortgages, to more defaults.
“It’s a challenging time, even if the Fed is done,” said James Ackor, an analyst at RBC Capital Markets, “because it’s not entirely clear what kind of damage has been done as a consequence of the Fed activity.”
What many in the industry do know is that the mortgage REIT sector was hit by a triple whammy: higher short-term rates, along with, oddly, falling long-term rates, and a continuing wave of mortgage prepayments from refinancing. Of course, some mortgage REIT’s fared better than others. There are 33 in all; 22 focus on residential mortgages and the remainder on commercial, according to the national REIT association.
On the residential side, diverse business models and investment strategies mean that each REIT “has to be looked at separately when determining the impact of changing rates on their performance,” explained John J. Kriz, a managing director for real estate finance at Moody’s Investors Service.
Some residential mortgage REIT’s, like the American Home Mortgage Investment Corporation, the HomeBanc Corporation and New York Mortgage Trust, own subsidiaries that originate home loans. These “active” REIT’s have generally done better in an environment of rising interest rates than “passive” REIT’s like Annaly Mortgage Management and Luminent Mortgage Capital, which buy mortgage securities, analysts say. Other REIT’s, like the Thornburg Mortgage Asset Corporation, have both active and passive investment strategies.
The passive REIT’s were especially hurt by the flattened yield curve as short-term rates rose faster than long-term ones. No longer were they able to borrow at low short-term rates, then turn around and invest that money at higher rates in longer-term securities, a strategy that had yielded rich profits before the Fed began tightening its credit policies to stave off inflation.
As a result, some mortgage REIT’s have had second thoughts about sticking with the REIT business structure, which requires them to disburse at least 90 percent of their earnings as dividends in exchange for tax benefits. Many investment funds originally converted to REIT status because of the success of REIT’s in attracting capital.
“When things get rough, we see a tendency to de-REIT,” Mr. Miller said, explaining that if a fund gives up its REIT status, it can retain more of its earnings and seek other ways to raise revenue.
Analysts are also expecting some REIT companies to exit the residential mortgage business or to merge with other companies. This month, MortgageIT Holdings, a mortgage originator, announced that it had agreed to be acquired by Deutsche Bank for around $429 million. Another REIT, the Aames Investment Corporation, which lends money in the subprime market — borrowers with weak or impaired credit — agreed last spring to be acquired by Accredited Home Lenders for $340 million.
Although the business environment remains challenging for home mortgage REIT’s as questions remain about the direction of interest rates, many analysts advise investors to stick with the more established REIT’s in the home mortgage sector.
Mr. Ackor says he likes American Home Mortgage, a mortgage originator, which recently raised its dividend to 96 cents a share from 91 cents and has reported a higher-than-expected number of mortgage originations.
“American Home has done a very good job over the course of the last few years, although it’s not the cheapest stock,” compared with other mortgage REIT’s, he said. Shares are trading at less than $35, though Mr. Ackor thinks they could go as high as $40.
He says he also sees future improvement for other mortgage originators like HomeBanc and New York Mortgage Trust.
Matthew Howlett, an analyst at the investment bank Fox-Pitt, Kelton, favors Redwood Trust, a passive home mortgage REIT, which he says has an “efficient operating platform and strong management team.” He was also positive about New Century Financial, one of the nation’s largest providers of subprime mortgage loans, which announced that its total loan production for May was $5.5 billion, an increase of 28 percent over May 2005.
An expanding subprime market, of course, means more opportunities for mortgage REIT’s, which, according to Jason Willey, an analyst at Standard & Poor’s, can certainly use the business. “We believe there is an increasing amount of capital chasing a smaller amount of opportunities,” Mr. Willey said in a report released last month. And, he said, this means that some REIT’s have been “forced to accept smaller returns, or take on greater risk, in order to secure business.”
Mr. Willey, like many others, says he believes that the sector’s fate is riding on the Fed as well as the overall health of the economy, particularly job growth — or at least the market’s perception of both.
Mr. Ackor said, “There’s a lot of psychology involved.”
posted by B at 3:27 PM
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