Home equity mortgage originators should hold on to their loans and convert to REITs, according to the cofounder of one of the country’s leading investment bankers.
Speaking at the recent Home Equity Secondary Summit in Lake Tahoe, Nev., Eric Billings promoted the virtues of using a real estate investment trust (REIT) structure to add value to an exisiting origination platform.
The nonprime mortgage market is “from our perspective, by far, the most attractive, the most interesting part of the financial services industry in the United States,” Billings told the audience, and “represents quite an extraordinary opportunity for varieties of reasons.”
One of the reasons is the market’s inability to differentiate between prime and nonprime, which has “obscured a lot of the great characteristics in the nonprime mortgage market — which creates great opportunity from an investment perspective.”
Billings, who is co-chairman and co-CEO of Friedman, Billings, Ramsey Group Inc. (FBR), said the nonprime mortgage market has brought in 15% compounded growth over the last 15 years, compared to 5% – 7% for the prime market. He expects the nonprime market, which has gone from no significant share of the total mortgage market 15 years ago to 10% of today’s $7 trillion market, to reach $2.5 trillion to $4 trillion within the next seven years.
The Washington D.C.-based speaker said that while some companies in the mid-nineties were built on structurally bad advice from capital markets — using gain-on-sale accounting, structurally strong companies lived through the chaos and were able to understand how to ensure that the total cost structure was covered by the cash earned. Currently, 20-25 companies dominate the nonprime market and “they are originating loans in volumes where the G&A is under control; its 250…basis points.
“Very fine business model,” Billings added, and pointed out that the capital markets accept the loan assets without reservation.
So how can today’s origination businesses be maximized?
First, the value created is in the ability to originate the loans. And while selling the loans can generate respectable one-time earnings, “maybe its a point after tax” with lots of volatility, Billings said that lenders holding on to loans in a spread-based structure can double or triple their return on those same loans.
Second, spread based businesses are capitalized anywhere from 10-18 times earnings — which for taxable entities could yield up to nine times greater value than the one-time sale earnings.
“And that’s if you pay tax,” Billings said. “What if you do it as a REIT — where you don’t pay taxes?
“The economic value is extraordinary in every way.”
Billings, cofounder of FBR, used an example of a $2 billion originator. If that originator does not plan to grow or shrink production and the average loan lasts three years, then the portfolio will reach an equilibrium point (where runoff equals originations) of $6.5 billion.
In a REIT structure, Billings said the entity will earn 200 basis points, or $130 million.
“It is worth something in the vicinity of $1.5 billion to $2.5 billion,” he noted, and added that equity capital of $450 million would be needed to capitalize $6.5 billion in loans.
“Raising the capital is easy,” according to Billings. “REITs are great businesses…returns on investment equity are extraordinary and are sustainable” And even though the capital markets don’t understand these businesses now, they will in the future and value them accordingly.
In stressing the value of the REIT structure, Billings said the REIT Modernization Act of 2001 allows “taxable REIT subsidiaries to be housed inside of larger REIT corporate structures.” This enables the REIT to avoid distributing all earnings from all entities and build equity.
Billings’ company puts its money where his mouth is. He said that FBR, which is “the fifth largest capital raisers in the United States,” is a REIT.