Mortgage vehicles are wrong kind of REIT for government

Government backs resi REITs rather than commercial property debt vehicles, writes Doug Morrison

The property industry is used to fighting hard for any concessions to the UK’s evolving real estate investment trust (REIT) market – and nowhere more so than with the idea of extending the tax-transparent regime to include property debt companies.

None the less, bankers and advisers dared to hope the March Budget would open a consultation on so-called mortgage REITs, with a view to introducing them in 2013.

However, chancellor George Osborne wrong-footed many by ignoring mortgage REITs and opting instead to explore the prospects for social housing REITs (see below), in what looks increasingly like a political gesture to ease the UK housing crisis.

A REIT without the underlying real estate was never an easy sell in Whitehall. Osborne, or Treasury officials, seem to have picked up on the doubts, dismissed the possibilities and, as one investment manager puts it, promptly dumped their mortgage REITs file into the “too difficult box”.

Yet for supporters of mortgage REITs, the potential benefits of such vehicles, which so encouraged optimism in the run-up to the Budget, remain as persuasive as ever.

In principle, mortgage REITs could expand the number of potential buyers of the loans  banks no longer want and create a new debt  finance source for property. This would be especially useful with an estimated £100bn of property debt due for refinancing by 2014, much of it held by the state-owned Royal Bank of Scotland and Lloyds Banking Group. Until the Budget, mortgage REITs were seen as part of the solution. According to some, they could still play a role.

Frustration with the Treasury

The pro-mortgage REIT lobby have partly been frustrated by internal machinations at the Treasury, whose REIT specialists held informal talks with industry advisers last year. But as Peter Cosmetatos, the British Property Federation’s director of finance, points out: “Mortgage REITs, as debt funds with a real estate focus, are perhaps of greater interest to [Treasury] people who look after banking and credit than those who look after property taxes.”

The other big frustration is that as the mortgage REIT bandwagon started to roll last year it was seen primarily as a means of dealing with distressed debt – something of a misconception.

Cosmetatos says: “The REIT concept is principally a relatively boring, safe, bond- like, long-term income stream, underpinned by property. That does not shout ‘risky distressed debt’, where you are maybe able to make a lot of money, but better-quality loan assets, where there is an income stream and you can be paying distributions.”

These views are echoed by Marion Cane, executive director and property tax specialist at Ernst & Young, who spoke to the Treasury about mortgage REITs after taking soundings of support from a wide range of potential stakeholders, including main-stream institutional investors.

“Mortgage REITs would sit alongside the lending markets and provide an additional source of lending,” she says. “Banks’ capacity to lend to commercial real estate is much reduced by regulatory pressure to boost the capital on their balance sheets. There is a significant lending gap, unlikely to be filled by the insurers or debt funds.

“So, based on talks with various parties, they would buy debt originated by lenders, according to the criteria of their investor base. They would look for a certain quality of debt, underlying cashflow and tenant that would deliver stable, secure income streams. Not distressed debt – that is for the private equity funds.”

Housing REITs are political priority

Cane adds: “The government is focused on increasing housing supply, which is obviously really important and that’s principally what the recent REIT changes have been geared around. When we spoke to the Treasury, they were very concerned that if we had mortgage REITs as well, that might undermine the residential policy.

“I suppose they thought investors might go for mortgage REITs instead of residential REITs, but they would be very different animals appealing to different investors, due to the different nature of their returns “There is also an obvious positive link –  if mortgage REITs were there, maybe then there would be more funding for the development of housing.”

The Treasury declined to comment to Real Estate Capital, but officials told Cane: “The government judged there was not sufficiently compelling evidence at this stage to undertake a consultation.”

The scepticism extends beyond Whitehall to the City. Whereas the first wave of REITs involved conversion of established commercial property companies, mortgage REITs would require the assembly of management teams from scratch and a stock market flotation at a time when initial public offerings (IPOs) are scarce.

One specialist corporate financier, who declined to be named, says: “We’d all like to expand the REITs universe because, frankly, they’ve been disappointing. Mortgage REITs could help answer all the government-owned banks’ issues by recapitalising them through the capital markets.

“But the [property] sector opens for new IPOs about once every five years. To get a mortgage REIT ready at the same time as the equity markets are ready is tough.”

UK mortgage REITs would probably be different from those in the US, where  government-sponsored housing debt dominates a long-established sector. There are also US commercial mortgage REITs that operate without government backing, but as the financier notes, they trade at a massive discount to net asset value.

He adds: “Unless there’s some sort of government sponsorship, it would be really hard to make them work here. People aren’t going to buy them for a pound when from day one they’re worth 80p. REITs already trade at a discount to NAV so why would a mortgage REIT trade at a tighter discount to NAV? If you’re not trading at NAV then it’s very hard to float companies in our space.”

But Cane claims: “There is definitely an appetite for income-yielding investments and for real estate debt. But access to debt funds is restricted – there is usually a minimum investment and sometimes they are higher risk, with double-digit return expectations. We’ve been told many institutions would like to access secure investments yielding 6-8% returns.

“Mortgage REITs could be the right wrapper for institutional investors – a strong brand with liquidity, transparency and diversification benefits. It’s about packaging it up and getting a credible story about what mortgage REITs can deliver and their level of risk.

Conservative criteria to suit institutions

“Investors wouldn’t be taking high risks, [but investing in] relatively low-geared vehicles with conservative investment criteria. The sorts of portfolios they would invest in would have to give a great deal of comfort so there would not be a problem.”

Unfortunately for Cane and her prospec-tive institutional investors, the Treasury does not believe mortgage REITs’ story is credible right now. Even if there were to be a sudden government change of heart, the slow pace of legislative change means it would be 2014 before mortgage REITs came into force.

“I don’t think there is a clear, strong consensus that the thing we’re really missing and would really make a difference is mortgage REITs,” says Cosmetatos. “My main concern is that the government needs to anticipate that consensus, because I don’t think enormous resources are needed to promote a consultation and bring forward legislation to allow mortgage REITs.”

Cane believes momentum will build again for mortgage REITs, both through renewed property industry lobbying and necessity, bearing in mind “the distinct shortage of corporate real estate finance, particularly outside London and the south-east”.

She adds: “The connection needs to be made in the government’s eyes between the impact of regulation on the supply of credit, and the longer-term impact if property values fall off a cliff because existing loans can’t be refinanced, and new projects don’t get off the ground because sources of new loans have dried up. The impact of that could be more distress and problems for the rest of the economy.”

 A concept born in the USA – but with government backing

Mortgage REITs have been trading in the US since the early 1960s and today total 30 with a combined value of $50.2bn – about 10% of overall REIT market capitalisation. They buy existing debt and mortgage-backed securities, making profits from the difference between interest rates earned on mortgage loans and short-term borrowing rates.

There are two types of mortgage REITs – agency and non-agency. Agency loans are issued and guaranteed by national residential mortgage associations Fannie May and Freddie Mac. These dominate the sector by value; the leading mortgage REIT, Annaly Capital Management, has a $15.33bn market capitalisation.

Non-agency mortgage REITs tend to involve commercial property loans and are considered riskier investments. Calvin Schnure, vice president, research and industry information at the National Association of Real Estate Investment Trusts points out that, much like the UK, the big opportunity for US mortgage REITs lies in the acknowledged requirement for refinancing US property debt.

Here it involves restructuring Fannie May’s and Freddie Mac’s balance sheets as well as refinancing loans held by the US Federal Reserve. “About $3 trillion needs to be recapitalised over the next half decade, so that’s what has caused more interest in mortgage REITs as a well-regulated, transparent mechanism for bringing private capital into the mortgage business,” Schnure says.

Housing associations may hold the key to resi REITS

Successive governments have struggled in vain to foster the UK’s first residential REIT and now the coalition hopes housing associations can succeed where private landlords have failed.

If the consultation on social housing REITs, which is due to close on 27 June, goes as the coalition wishes, housing associations could convert to REITs as early as next year, although this may not necessarily be the best option for the associations or prospective investors.

Around 90% of the sector’s bank debt is due for refinancing in the next five years, while traditional government grants have been slashed. But the sector’s leading players have increasingly tapped the bond market for funding – for those investors, the stability of housing association income is attractive.

Geeta Nanda, chief executive of Thames Valley Housing Association, welcomes the new initiative but concedes that REIT investors would have to offset high returns for greater security.

“As long-term businesses with index-linked rents, we would seem to be the  ideal investment for pension funds,” Nanda says. “The queries, however, relate to the level of returns. Currently social housing returns are low and to achieve  the right returns, say 7%, rents would need to increase.”

Nanda adds: “The other query would  be about the treatment of grants, which currently sit on our balance sheet. It would need to be written out. Not all associations could participate.

“Housing associations would need to  be able to sell properties into the REIT or manage properties on behalf of it. Some associations have the assets and appetite to invest and some are interested in [forming] consortia.”