Mortgage REITS: Are They A Good Value?VW Staff
A Real Estate Investment Trust (REIT) is a company that owns, and in many cases operates, income-producing real estate. Some REITs also engage in financing real estate. There are two main types of REITs, a mortgage REIT which owns loans and obligations backed by real estate, and an equity REIT which invests in rental real estate, including shopping centers, office space, single family homes, and apartment buildings.
The REIT structure benefits investors, as the company is not taxed at the corporate level. Only investors pay taxes on profits, hence there is no double taxation on earnings. The characterization of taxable income is passed through to the stockholder, and dividends do not receive qualified tax treatment.
There are certain criteria a company must adhere with to be considered a REIT:
- At the end of each year at least 75% of a REITs gross income must be derived from qualified REIT assets, which include rents from real property, interest from mortgages, and income from the sale of mortgages and/or real property.
- At the end of each year at least 95% of a REITs gross income must be derived from assets that qualify under the 75% gross income test plus other qualifying income, which includes dividends and interest or gain from the sale of private and government securities.
- At the end of each quarter a REIT must have at least 75% of its total assets in real estate related assets, government securities, and cash.
- Non-investment activities, such as mortgage banking and hedging, have to be conducted through a separate taxable REIT subsidiary, or TRS. A REIT’s ownership of one or more TRS cannot be higher than 25% of the REIT’s total assets.
- A REIT must be held by a minimum of 100 stockholders and concentration is limited to a maximum of 50% direct or indirect ownership by any 5 owners.
- A REIT must pay out at least 90% of its taxable income to stockholders. REITs typically provide high dividend yields as compared to the broader market due to this rule. Oftentimes, mortgage REITs pay out closer to 100% of their taxable income. Because a REIT is required to comply with its taxable income distribution requirements on an annual basis, the tax characterization allocation of each of its dividends declared throughout the entire taxable year are not determined until after December 31st. The tax characterization allocation is reported to the shareholder on a Company’s Form 1099-DIV, which is available to the shareholder in January or February of the following calendar year.
There are 2 fundamental Investment Company Act of 1940 exemption requirements the REITs must adhere with to avoid special registration requirements and regulations by the SEC:
- If 80% or more of a REIT’s assets are composed of qualifying real estate assets, the company can be exempt from registration as an investment company.
- If at least 55% of the REIT’s assets consist of assets where the REIT owns an entire fixed pool of securitized mortgages, then the company can avoid registration as an investment company.
The REIT industry’s market cap is approximately $609 Billion, of which mortgage REITs represent a market cap of about $59 Billion. There are two types of mortgage REITs, residential mortgages (agency REITs, non-agency REITS, and hybrid (contains both agency and non-agency REITs) and commercial mortgages.
There is an opportunity for mortgage REITs to increase their investments as government participation in the mortgage market has shrunk. Mortgage REITs may fill the gap to satisfy capital demand.
Investing in mortgage risk involves four types of risk:
- Interest Rate Risk: Sensitivity to changes in interest rates – if rates increase, the value of REITs could decrease. The outlook for interest rates is stable for the rest of 2013, as analysts expect the Fed to not increase interest rates. Hence low long term rates will continue to be available lowering cost of financing and hedging costs against higher rates.
- Prepayment Risk: Uncertain cash flows as debtors may make larger payments shortening duration of mortgage bonds. Management of this risk depends on security selection REITs employ, and investors should consider REITs that are effective at mitigating this risk.
- Mortgage Credit Risk: Losses due to nonpayment of borrowers. REITs mitigate this risk by doing credit research and security selection.
- Liquidity Risk: Leverage may impact returns adversely if broader market corrects
Overall, the outlook for mortgage REITs is positive, as housing prices improve and supply/demand trends are favorable. Refinancing has stabilized as the effect of QE3 is fading and repo rates could decrease modestly improving cost of financing and net interest rate spreads. In turn, dividend payments could be more stable, along with mortgage REITs book values. The favorable interest rate and improving housing market could favor hybrid mortgage REITs that hold non agency RMBS, which are trading above book values, as the market has already included possible price appreciation. Agency REITs appear to have more downside and less upside relative to hybrid mortgage REITs.