Subprime Lending Fallout

Turmoil over subprime lending in the single-family home market is taking a toll on mortgage real estate investment trusts. Through June 19 of this year, the mortgage REIT industry posted a total return of negative 13.40%, a huge swing from the 19.32% return posted for all of 2006, according to the National Association of Real Estate Investment Trusts (NAREIT).

Residential mortgage REITs have been hit especially hard, posting a total return through June 19 of negative 15.90%. That's a dramatic reversal from 2006 when their total return was a healthy 14.75%.

Among the most battered companies is New Century Financial Corp., which invested heavily in subprime residential mortgages and filed for bankruptcy protection in early April. Another is New York Mortgage Trust, which announced in February that it was exiting the residential mortgage market. The New York City-based REIT posted a first-quarter 2007 return of negative 35.29%, according to SNL Financial in Charlottesville, Va.

The worst may be yet to come. Some predict that within the next several years, many residential mortgage REITs operating today — even some with little exposure to subprime loans — will disappear as a result of mergers, acquisitions, bankruptcy, or dissolution triggered by problems related to subprime loans.

Meanwhile, analysts say that commercial mortgage REITs also are feeling the heat as investors watching the residential mortgage REIT market begin to question whether commercial real estate loans are on solid footing. “Commercial mortgage REITs are down quite strongly,” admits Brad Case, NAREIT's vice president of research and industry information.

Indeed, commercial mortgage REITs posted a total return of negative 8.92% year-to-date through June 19, according to NAREIT, compared with a whopping 30.31% return for all of 2006. (Total returns include stock price appreciation plus reinvested dividends).

The list of commercial real estate mortgage REITs experiencing problems includes American Mortgage Acceptance Co. of New York, which posted a return of negative 38.9% in the first quarter of 2007, according to SNL Financial. Meanwhile, Capital Trust Inc., a New York City-based REIT, reported a return of negative 16.24% during the same period. The news wasn't any better at NorthStar Realty Finance Corp. of New York, which posted a return of negative 16.03%.

Shaky ground

REITs invest in income-producing real estate and distribute at least 90% of their income as dividends. Mortgage REITs are a subset of REITs that invest not in real estate, but in loans secured by real estate, including residential and commercial mortgages and mortgage-backed securities. Some mortgage REITs also borrow from banks to lend money to investors, profiting from the spread between the two rates.

According to NAREIT, there are 31 U.S.-based mortgage REITs on the FTSE NAREIT US Real Estate Index, 17 investing in residential mortgages, 14 in commercial mortgages. Some residential mortgage REITs, though NAREIT can't say how many, have invested in subprime loans, or loans to borrowers with weak credit ratings. Subprime loans often contain artificially low teaser rates for a few years that eventually transition to higher long-term interest rates. A growing volume of subprime loans in recent years has resulted in record-level defaults as borrowers struggle to make the higher payments.

The Mortgage Bankers Association reported that the percentage of subprime residential mortgages in the first quarter of 2007 that were 30 or more days past due but not in foreclosure increased to 13.77%, up from 13.33% in the fourth quarter of 2006. In addition, in May 2007, there were 176,137 residential foreclosure filings in the United States, 90% more than the May 2006 total of 92,746, according to RealtyTrac Inc., an Irvine, Calif., company that compiles foreclosure data.

The rising number of delinquencies and foreclosures in the housing market has been a drag on the entire mortgage REIT market. “The subprime problem isn't good for mortgage REITs,” says Eric Fitzwater, associate director and senior analyst for financial services and insurance at SNL Financial. “The demand for the residential mortgage REIT product has been questionable for the last 18 months, and we're not sure the residential mortgage market has bottomed out yet. It's on shaky ground.”

For instance, Fieldstone Investment Corp., a subprime residential lender based in Columbia, Md., posted a return of negative 11.19% in the first quarter of 2007, according to SNL Financial. After announcing a merger in February with New York City-based Credit-Based Asset Servicing and Securitization LLC, Fieldstone said in April that it was cutting about 125 employees and closing nine retail branches. SNL reports that Irving, Texas-based American Home Mortgage Investment Corp. also posted a dismal first return of negative 32.93% in the quarter 2007.

Skittish investors

Relying on composite numbers to understand what's happening in the residential mortgage REIT market can be misleading, says Bose George, an equity analyst who specializes in mortgage REITs and subprime lenders at Keefe, Bruyette & Woods Inc. in New York City. The residential mortgage REIT market has “bifurcated,” George says.

The first category is what he calls investment REITs, or those with little risk because they invest in mortgage-backed securities. “That sector has outperformed the mortgage banking REITs this year,” he says. The second are mortgage banks in the subprime lending business. “Those will probably have a very weak year,” predicts George.

The problem is that investors aren't drawing a distinction between the two entities. They've become “skittish” about mortgage REITs regardless of the type of loans in which the REIT invests, says NAREIT's Case. “Investors don't really understand the kinds of loans that are invested in by the companies they purchase stock in and decided it's safer to sell rather than find out the real story. In early 2007, a lot of mortgage REITs took a hit on their stock price that wasn't justified.”

Greg Sukenik, a senior REIT analyst for Zacks Equity Research in Chicago, says the hit on all mortgage REITs isn't surprising. “People tend to paint the whole mortgage REIT sector with the same brush, although REITs do different things,” he says.

That, however, isn't smart investing, says Case. “There's no indication that the kinds of problems in the subprime residential market are happening in the commercial mortgage market,” he says.

Fitzwater of SNL believes commercial mortgage REITs are suffering because investors' wariness of residential mortgage REITs is causing liquidity problems. Major banks and warehouse lending companies, which typically provide funding for mortgage REITs, have stopped lending to mortgage REITs, and they can't operate on the cash flow they generate. “If your inflow dries up, your business comes to a screeching halt,” says Fitzwater.

Wake-up call

Dale Anne Reiss, Ernst & Young's global and Americas director of real estate, hospitality and construction in New York, says investors may be reacting to two issues rippling through the market. As the subprime issue has washed over the market, properties that were in the Equity Office Properties Trust (EOP) portfolio acquired in February by The Blackstone Group have been sold and resold.

There's been a wake-up call in the commercial debt market, Reiss believes. “Whether it's due to what's happened in the subprime market, or whether it's from the flips and re-flips of properties out of the Blackstone-EOP deal, I don't know. I think it's a combination of the two. The Blackstone-EOP deal put a large amount of highly visible, highly leveraged, high-priced property in the debt market all at once, and that forced a reexamination of the debt prices right on the heels of the subprime situation,” according to Reiss.

Joe Betlej, a portfolio manager at Advantus Capital Management in St. Paul, Minn., which manages real estate securities portfolios, is one of the investors who's backed away from commercial mortgage REITs. After the subprime lending fallout in the residential sector, investors began to scrutinize other investments.

“Debt investors started looking around to see if there were any other parts of the market where risk wasn't appropriately priced,” says Betlej. “Commercial mortgage loans were going through a massive re-pricing because the question in the market was whether you were getting the appropriate return for your investment in a commercial mortgage loan. The market clearly said no.”

The re-pricing has caused available financing to “dramatically decline,” says Betlej. “Gone now are interest-only loans,” he says. “You don't have negative amortization loans available. The business model for many commercial mortgage REITs is based on production. If they're not able to find new loans at an increasing pace, that's not going to increase their earnings. That's why we exited,” adds Betlej.

Before he'll re-invest in commercial mortgage REITs, Betlej says that several events will have to happen. “First, we'll need a much more clear understanding of credit underwriting standards for commercial mortgages,” he says. “Second, we'll need to see volumes of new commercial mortgage originations picking up.” Of course, boosting volume requires ready financing, but as both Fitzwater and Betlej note, financing is becoming more scarce.

Congress to step in?

Federal lawmakers have held hearings on the growing default rate in the subprime residential market, but none have introduced legislation to aid borrowers currently in distress or to restrict future lending. Though the U.S. Federal Reserve Bank has said it will consider tightening lending rules, if the problem continues to grow, the likelihood of Congressional action increases. Experts admit the residential lending business needs more stringent regulation, but they worry about how much Congress might tighten the screws.

“For the mortgage market long-term, some regulation is probably a good thing in the subprime space,” says George at Keefe, Bruyette & Woods. “There are advantages to the banking model where regulators are around and there's some adult supervision.”

The risk is that Congress will go overboard, he says. “This is already a liquidity crisis. Capital has backed away from lending to subprime borrowers, and the concern is that Congress will make it even harder for capital to get to borrowers who'll need it to refinance over the next couple of years,” says George.

If borrowers can't get new loans, that won't be good news for struggling residential mortgage REITs, though the industry as a whole might benefit. “It'll put a squeeze on companies that could have survived if legislation hadn't been involved,” says Fitzwater. “But it'll also shake out players that shouldn't have been there in the first place. That's good for long-term companies.”

NAREIT's Case doesn't dispute that there may be consolidation in the residential mortgage REIT industry, saying it's normal for the number of REITs to ebb and flow in response to market conditions. Case agrees that there will be mergers and acquisitions, and he even says there may be initial public offerings of new mortgage REITs.

Fitzwater, however, is dubious about initial public offerings. “They're done,” he says. “The mortgage market is in a trough, and nobody's going to do an IPO under these circumstances.”

G.M. Filisko is a Chicago-based writer.

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