Mortgage REITs Lose Curb Appeal
As the Housing Market Slows

Two years ago, mortgage companies were rushing to restructure themselves to become real estate investment trusts, hoping to benefit from investors' strong appetite for anything related to the housing market. But now, some REIT executives -- and investors -- are having second thoughts.

"Being a mortgage REIT isn't as great as it seemed at first," says Tara Innes, a managing director at credit-rating company Fitch Ratings Ltd. "Over the last year, the promise of being a residential-mortgage REIT evaporated."

REITs are securities that allow investors to own shares in companies that manage different aspects of the real-estate market and pay out 90% of their earnings to investors as dividends. According to the National Association of Real Estate Investment Trusts, overall total returns for REITs peaked at 38.5% in 2003 and eased to 8.29% in 2005. As of May 31, REIT returns were 7.42%.

Returns for equity REITs -- companies that own office buildings and shopping malls -- were similar to the overall averages. But total returns on residential-mortgage REITs have been more volatile: They were up 42.73% in 2003 and posted a negative 25.95% in 2005. As of May 31, they were up 9.23%.

Last year's dismal performance partly explains the recent flurry of companies announcing changes. Last month, Accredited Home Lenders agreed to acquire Los Angeles-based REIT Aames Investment for $340 million. Aames, a subprime lender, has been in red ink for the past two quarters, with a first-quarter loss of $13.5 million, or 22 cents a share. In April, Irvine, Calif.-based ECC Capital Corp. said it was advised by its bankers to consider, among other things, converting away from its REIT status so it can retain more of its earnings to turn around the company. ECC specializes in "nonconforming" borrowers who have weak credit or don't have the collateral or documentation required by conventional mortgage lenders. ECC Capital reported a net loss of $6.4 million, or six cents per diluted share, for the three months ended March 31.

Mortgage companies began converting to REITs in 2004, hoping to follow in the footsteps of equity REITs, which at the time were Wall Street darlings. Mortgage-bank earnings were high and stock prices were surging. By converting to REITs, the mortgage banks expected their stock prices to rise further, in part because REITs are taxed at a much lower level -- as much as 35% less -- than corporations. That meant more money could go back to investors.

Initially, the conversions seemed to work. "You have residential-mortgage real estate becoming a favored asset class," says Brian Harris, a senior credit officer for Moody's Investor Service. "All of that contributed to good performance for the sector." Total returns for residential-mortgage REITs were 24.91% in 2004, the year that most of the conversions took place.

By 2005, conditions quickly turned. First, the housing market started to slow and the volume of new mortgage-loan originations weakened. At the same time, the Federal Reserve pushed short-term interest rates higher, prompting mortgage companies to pay more to borrow money to make new mortgages. Moreover, concerns about a housing slowdown reduced investor appetite for mortgage securities. That meant mortgage companies weren't able to make as much money for their mortgages when they tried to package them and sell them off as securities on Wall Street. For example, revenue margins on subprime loans have narrowed to about 2.5 percentage points from about 3.5 to 4 percentage points a year ago, says Edwin Groshans, a senior mortgage analyst with equity research and investment-banking firm Fox-Pitt, Kelton. Margins on prime mortgages grew even thinner.

Some analysts believe conditions in the industry will worsen before they improve. The Mortgage Bankers Association predicts that mortgage originations will drop 14% this year. "There's so much competition out there and the volumes have shrunk. So it's becoming very price competitive. That's reducing profitability," says Mr. Groshans. "As your business becomes less profitable, your weaker players fall out of bed."

While slowing home sales are hurting all types of mortgage companies, residential-mortgage REITs find that their tax status limits how quickly they can respond to changing market conditions because REITs can't preserve much of their income. If they give up their REIT status, the companies can retain more of their earnings and experiment with additional methods of raising revenue beyond originating mortgages, says Mike Fratantoni, a senior economist with the Mortgage Bankers Association.

"There are some companies that decided that 'Yes, the REIT structure is not working for us,' " says Mr. Fratantoni. "If you become a thrift or a bank, you have greater flexibility, more opportunities and greater liquidity."

To be sure, analysts say that some mortgage REITs will be able to weather a rocky market and perform well over time. Followers of mortgage REITs say their success depends on keeping down the costs of creating mortgages. That means curbing expenses like technology, compensation for sales representatives and running retail operations. "Depending on their business models, for some companies, it's working very well and they're happy with it," says Fitch's Ms. Innes.

Accredited Home Lenders Chief Executive Jim Konrath says he considered converting to a REIT in 2004, but had some concerns. Among them: how the structure would help him achieve the value he wanted for the company's stock price, how exactly the REIT would be taxed for originating loans and how willing Wall Street would be over time to provide his company more capital to grow. "There were a lot of unanswered questions," says Mr. Konrath.

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