Fitch Ratings said its Updated Rating Criteria for Mortgage REITs and Similar Finance Companies released today was designed to address the significant growth of issuers operating as REITs.

Created by Congress in 1960, mortgage REITs avoid corporate income taxes but must pay out 90 percent of their taxable income as dividends, the report said. To qualify as a REIT, 75 percent of assets must consist of mortgages or other qualifying assets, 20 percent of assets may consist of securities of taxable subsidiaries, and no more than 5 percent can be invested in securities of a single issuer. A minimum of 100 shareholders is required with no more than 50 percent of shares held by five or fewer people.

With the REIT Modernization Act of 1998, firms of this structure were allowed to generate meaningful income through asset sales. The sector was stressed in 1998 when the Russian bond default and the failure of Long-Term Capital Management wiped out the market for widely used reverse repurchase transactions — or REPOs.

The asset quality in the group, which rely on both self originated and third party originated loans, varies from AAA-rated securities to subprime transactions. Fitch noted issuers with servicing operations may have a more defensible business model, while issuers with origination platforms are able to be more selective about asset quality.

But REITs “that originate assets for sale face unique regulatory and taxation challenges,” Fitch said.

Outsourcing can negatively impact ratings if the company gives up too much of the process, the report indicated.

While Fitch noted residential mortgage REITs are viewed less favorably than their commercial or hybrid counterparts, ratings are primarily based on financial position and operating performance. One hurdle especially facing young companies is diversity in funding their operations, which should include commercial paper conduit facilities, collateralized debt obligations and other committed facilities.

It is common for REITs to be externally managed, though internal management is preferred, the agency noted. A three-year operating history is also preferred, as younger firms have had little time to generate a core base of assets.

REITs should implement a hedging strategy for their investment pipeline, Fitch said.

“The mortgage REIT industry is composed of a much broader group of companies that own direct or indirect interests in various mortgages on real estate or other interests in real property,” Fitch said in a separate announcement.

Sam Garcia worked in mortgage lending for twenty years prior to becoming publisher of MortgageDaily.com.

e-mail: mtgsam@aol.com