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Patrick Harden is a Certified Public Accountant with three years of experience in auditing publicly-traded real estate investment trusts. For over two years, he was involved in the mortgage finance industry as a member of the financial reporting group at a publicly-traded mortgage bank. He has... More
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  • REITs Not Right for PPIP Players 1 comment
    Jul 13, 2009 10:22 PM | about stocks: IVZ, AB

    This week, Angelo, Gordon & Co. became the latest of the nine firms awarded the right to take part in the U.S. Treasury's Public-Private Investment Plan to file a prospectus for a new real estate investment trust.  These REITs are designed, of course, as tax-efficient vehicles to hold the legacy assets purchased through the PPIP.  AG follows in the footsteps of both AllianceBernstein (AB) and Invesco (IVZ), who have also thrown together newly-formed REITs for the same purpose -- loading up on distressed real estate debt with the government’s blessing. 

    While the concept of buying these toxic securities with governmental support is certainly straightforward enough, cramming all these marked-down assets into a REIT seems as short-sighted as the original underwriting on these deals.
     
    For one, these REITs will acquire the aforementioned securities in the secondary market at prices well below par value because of the credit risk associated with them. The difference between the purchase price and the face value of the securities acquired will be treated as "market discount" for tax purposes. Per IRS rules, market discount on a debt instrument accrues on the basis of the constant yield to maturity of the debt instrument and it is reported as income when any payment of principal of the debt instrument is made. For mortgage loans where payments are made monthly, accrued market discount will be included in income each month as if the debt instrument were assured of ultimately being collected in full.
     
    Furthermore, if (and when) these credit-challenged assets become delinquent as to mandatory principal and interest payments, the REITs will still be required to recognize the unpaid interest as taxable income. Similarly, taxable interest income will also be accrued and recognized for subordinate mortgage-backed securities (e.g. junior CDO tranches) at the stated rate, regardless of whether corresponding cash payments are received.     
     
    As if that weren’t enough, the Legacy Securities Program will require the asset purchasers to use the cash received from interest payments to make principal payments on the related indebtedness, effectively restricting the cash available for distribution to shareholders -- despite the recognition of taxable income from the interest payments.
     
    The upshot of it all is a significant risk that these mortgage REITs will have substantial taxable income in excess of cash available for distribution, forcing them to borrow more money under unfavorable market conditions or “take other actions” to satisfy the REIT distribution requirements. “Take other actions” is, of course, code for issuing more equity, probably in the form of common stock dividends. 
     
    Take a lesson from California and steer clear of these REITs, because no one really wants another IOU.

    Disclosure:  Author has no positions in any securities mentioned in this article.

    Themes: Real Estate and REITs Stocks: IVZ, AB
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