Mortgage REIT Magic

The origination market for the battered mortgage REIT sector has all but dried up, with few new loans being made. Many borrowers, even large commercial tenants, are simply trying to extend or modify existing loans. Even the few new borrowers in the market no longer meet most underwriting standards now that the securitization market is dead and the credit risk can't be offloaded. However, for those mortgage REITs who are largely match-funded with existing CDO liabilities and don't have immediate liquidity concerns, there is a question of how to best deploy loan repayments (and prepayments).

Enter a rather clever solution. Perhaps best thought of as an extension of marking CDO liabilities to market under FAS 159, a few mortgage REITs have chosen to begin buying back previously sold CDO tranches for cents on the dollar. The buy back of the CDO debt has many positive accounting implications. Assuming the CDO is consolidated and accounted for as a financing for GAAP purposes, the repurchase of the CDO debt allows the original issuer to extinguish the CDO liability on its books, reducing leverage ratios and more importantly, generating a gain on the extinguishment of debt. This gain is also a source of taxable income, allowing mortgage REITs who are facing realized tax losses from foreclosures to offset these losses and potentially support their existing dividend payouts.

Gramercy Capital (GKK), for example, utilized this model during its second quarter, repurchasing $37.8 million of BBB to A+ rated CRE CDO bonds previously issued by Gramercy’s CDOs, generating gains of $17.6 million. These gains partially offset Gramercy's additional $23.2 million in loan loss provisions and allowed the Company to maintain funds from operations just above its dividend payout.

The purchase of the senior CDO debt would be even more effective for those REITs struggling with qualification issues. In addition to the positive accounting effects noted previously, the senior note holders have control over whether a CDO is liquidated once an event of default is declared. The repurchase of the senior CDO debt would allow the issuing REIT to recapture the diverted cash flow and allow the REIT to prevent the liquidation of the CDO and thus preserve the recognition of qualifying REIT income. Of course, the issuing REIT would have to proactively seek to repurchase the senior CDO debt before it becomes obvious that the CDO is in trouble.

Mortgage REITs may be up against a wall when it comes to originating attractive new investments, but they shouldn't forget about the magic that can be made by rediscovering old ones.

Disclosure: none

Comments

[Owen:]

I'm confused by the statement "allowed the Company to maintain funds from operations just above its dividend payout". Aren't REIT dividends based directly on their current FFO? I thought REITs had to, by law, distribute between 90% and 100% of their FFO as dividend, with any amount exceeding that having to be listed as "return of capital". If that's true, then--by definition--funds from operations would always be just above the dividend payout.

2008 Jul 27 10:36 AM

[notsosmart:]

you heard of shell games.now its just paper games. its all becoming more & more of a scam.the few making money on these games must be laughing while the masses have no idea of whats going on as the insiders build their fortunes for their kids,grandkids etc.

2008 Jul 27 11:08 AM

[Patrick Harden:]

REITs are required to distribute as dividends at least 90% of their ordinary taxable income. This is the metric that drives the dividend for most mortgage REITs. Because Gramercy Capital's sponsor is a large equity REIT, however, Gramercy follows SL Green's practice of disclosing funds from operations instead of taxable income. Generally speaking, FFO and taxable income should be roughly similar; however, this is not always the case for mortgage REITs. Gramercy's practices are not the norm for the mortgage REIT sector and I believe they should disclose taxable income as well as FFO. Given the merger with AFR, however, it may well be a moot point now.

2008 Jul 27 01:11 PM

[texasgolfer:]

if it looks like a scam, and seems like a scam, and finds support in paper "valuations" then it is probably too good to be true and isn't.

2008 Jul 27 01:42 PM

[Owen:]

Thank you, Patrick! Evaluating mortgage REITs has always been somewhat of a mystery to me, and your fine article and reply certainly help clarify some of this enigma.

2008 Jul 27 01:58 PM

[notsosmart:]

clarification is good. all the games in vegas & other casinos are very clear. most still lose. wall st.is now vegas,slower & nobody brings a drink.

2008 Jul 27 04:05 PM

[Patrick Harden:]

I didn't mean to imply that debt buyback was a scam. In fact, it is a very attractive investment for mortgage REITs who believe their CDOs are trading below the present value of their expected future cash flows. Shouldn't the manager of the CDO be in the best position to judge the CDO's future performance? Many of these asset-backed bonds are "money-good" but currently are priced to reflect a severe liquidity discount. It just makes sense to buy back the debt, delever your balance sheet, and offset your taxable losses with taxable gains.

2008 Jul 27 05:24 PM

[notsosmart:]

oh yea-all these guys are good decision makers.great management.

2008 Jul 27 10:55 PM