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REIT Structure Sank Lenders


REIT Structure Sank LendersCash depleted during good times, gone in bad

May 30, 2007


A flaw in the structure of real estate investment trusts proved to be fatal for some subprime lenders, according to analysts and executives surveyed by They noted required cash distributions during good times robbed the companies of much needed cash when things got rough.

A major problem is the inability to create the necessary reserves for the all-too-frequent loan repurchases when REITs are required to pay out a minimum of 90 percent of earnings to stockholders, they say.

“The REIT structure, our colleagues in the financial institutions area have felt for many years, is potentially incompatible with the lending business because of the difficulty in creating reserves,” Lisa Sarajian, managing director of the real estate finance group at Standard & Poor’s, told

“And subprime mortgage REITs are basically monoline lenders that don’t have the ability to easily retain capital to create a cushion for potential rough patches.”

While mortgage REITs can “generate some very outsized returns” during robust times, she pointed out, “when things get tough or when you have delinquencies and defaults you certainly want to have a balance sheet that can absorb that activity so the enterprise can continue lending.”

“The REIT structure is not the structure for subprime lending because you’re dealing with high risk assets,” Larry Goldstone, president and chief operating officer at Santa Fe-based REIT Thornburg Mortgage, told “If you had a structure where you could retain your earnings and not pay them out in dividends that would work better in terms of creating a viable business.”

Instead, REITs have to finance their balance sheets in the capital markets and thus must instill confidence in those capital markets or lose this important source of funding, something that New Century Financial Corp. failed to do, he said. Further, New Century was too aggressive in its earnings assumptions about loan performance and loan cash flows.

“When you’ve booked more income than you should have and paid out those earnings in cash [dividends], you can’t go back to shareholders and say, ‘Give us back the money. We shouldn’t have given it to you in the first place.”

“New Century didn’t book the [anticipated] loan repurchases correctly,” Goldstone explained, “and when they had to restate their earnings and ended up with two consecutive [quarterly] losses that was a violation of their warehouse lending covenants and new terms and conditions were set that New Century could not meet.”

Subprime lending also is a more costly business than is prime lending because there is “lots of overhead, lots of employees” and higher commissions paid to brokers, according to Goldstone. “And 2/28 loans do not generate enough income,” he added.

Thornburg, as a portfolio lender of prime mortgages, he noted, has avoided the finance problems of most mortgage REITs, especially REITs that specialize in subprime loans.

“Mortgage REITs are able to make reserves,” Ernest Napier, head of S&P’s specialty finance team, told, “but the rules have been tightened, making it harder justify higher reserves during good times. The REIT structure does not allow you to retain [much] capital in good years. And there was a lot of denial going on in the industry. Because things had gone so well for so long, the industry as a whole was overly optimistic.”

And when the mortgage business began suffering from a downturn, and originators such as New Century were not doing well and needed additional capital, it was no longer available, he said, a regularly occurring situation that S&P has always seen as a weakness of mortgage REITs.

Faced with these and other challenges, some associated with the downturn in the mortgage business and the accompanying decline in earnings available for distribution to shareholders, several mortgage REITs are surrendering their REIT status.

Kansas City-based subprime lender NovaStar Financial Inc., after 10 years as a mortgage REIT, will be surrendering its REIT status next January 1. But until then it has agreed to pay out 90 percent of its 2006 taxable income to shareholders in the form of notes, bonds, debentures or stock instead of cash, as agreed to in return for $100 million in financing from Wachovia Capital Markets LLC.

“Because there are a lot of restrictions and rules associated with being a REIT, the company concluded that the benefit to shareholders was no longer there but our costs would still be there if the company remained a REIT,” spokesman Richard M. Johnson explained to

When origination volume was high, the taxable income that needed to be distributed to shareholders was high but that situation has reversed itself and with an anticipated little or no taxable income over the next several years, no dividend would be required, he pointed out. But as a non-REIT or C-corporation, NovaStar expects to generate earnings which will benefit shareholders.

Meanwhile, NovaStar has reserved for expected losses, he says, particularly on some ’06 loans.

Atlanta-based HomeBanc Corp., which focuses on prime lending, also is ending its operation as a REIT. When announcing that decision, HomeBanc Chairman and CEO Patrick S. Flood said the move would enable HomeBanc to retain future earnings and grow book value in the long term.

“We wanted to preserve our capital for reinvestment in our business,” Mark Scott, vice president, corporate marketing, told “That could be for anything, including strategic things to make the company function better. If you have to pay out a great deal of money in dividends, you don’t have that option.”

Irvine, Calif.-based Impac Mortgage Holdings Chairman and CEO Joseph Tomkinson has been quoted as saying his company has been reducing its REIT taxable income, but company officials, when repeatedly contacted by, would not say how and why this was being done.

“Things normally move in cycles,” concluded S&P’s Napier. “People move in one direction and then a certain event occurs and people move in another direction. What we’re seeing is pretty normal. At some point, REITs will become very fashionable again.”


Jerry DeMuth is an award winning journalist who has been reporting for four decades.

e-mail Jerry at

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