Welcome to Ladenburg REIT

What is a REIT?

In 1960, Congress enacted the real estate investment trust tax provisions. REITs own or manage real estate or mortgage-backed securities and allow investors access to professionally managed portfolios. Investors do not need to invest significant capital to invest in the industry and receive a return that is not taxed at the REIT entity level. To qualify for REIT status the company is required to distribute a minimum of 90% of their taxable income to shareholders. As the majority of earnings are paid to shareholders, growth typically comes through additional equity issuance. Return to shareholders is predominately in the form dividends and to a lesser extent share price appreciation. As the REIT is not taxed, the shareholder’s dividend is taxed at the ordinary income rate.

Mortgage-Backed Securities

When a bank or other finance company originates a mortgage it can either hold it in its portfolio or sell it into the secondary market. In the secondary market loans are packaged and securitized into bonds that are then sold to mortgage investors. These mortgage-backed securities (MBS) represent an ownership interest in a pool of mortgage loans. In the typical structure, all principal and interest payments are passed through directly to investors.

In addition, any additional principal that is paid if a mortgage is paid off flows through as well. This creates pre-payment risk for mortgage investors. Mortgage REITs expect a certain amount of pre-pays as home-owners sell one house to move into another. However, pre-pay rates increase when rates are declining as home-owners refinance to a more attractive rate. The REITs are then forced to reinvest the proceeds at lower rates. Additionally, if the REIT paid a premium for the security, that premium must be fully amortized in the current period. Conversely, in a rising rate environment home-owners do not refinance and may choose to stay in their current house. The REITs are then forced to hold the lower yielding securities and are unable to reinvest at higher rates.

Agency Only

The most basic mortgage REIT structure is the Agency only REIT. The companies have investment portfolios that are primarily comprised of residential mortgages and MBS that are guaranteed by U.S. Government Agencies, primarily Ginnie Mae, Fannie Mae and Freddie Mac. They may also from time to time own US Treasury Securities. As these underlying investments are guaranteed, there is minimal if any credit risk in the portfolio. Due to the credit profile of the portfolio, the repo counter-parties are comfortable providing higher leverage and funding cost is relatively inexpensive. Leverage on a GSE guaranteed MBS portfolio typically is in a range of 6x to 9x.

Hybrid Residential

Like the Agency-only REITs, the Hybrid residential REITs purchase agency backed securities. They also purchase residential MBS that are not backed by the agencies. Unlike the agency securities, these securities have credit risk. Due to this risk, leverage on the non-agency part of the portfolio is typically significantly lower than it is on the agency portion.


The final sub-segment of the mortgage REIT industry is the hybrid REIT. Hybrid REITs invest in agency and non-agency residential securities as well as commercial mortgages and Commercial mortgage backed securities (CMBS). Leverage is varied based on the composition of the portfolio. Agency MBS can be levered much more than non-agency MBS and CMBS.

The Mortgage REIT Structure

Mortgage REITs borrow at the short end of the yield curve, typically via repurchase agreements, and use the proceeds to purchase mortgages or mortgage backed securities (MBS). The model is illustrated below and is for informational purposes only:

Yield on Portfolio 5%
Cost of Borrowing 3%
Net Interest Spread 2%
Debt to Equity Ratio 6X
Yield on Unlevered Portion 5%
Yield on Levered Portion (2% x 6) 12%
Gross ROE 17%

Risk Factors

Risk Factors Include but not Limited to:

  • Interest Rate Risk - Interest rates can move in unexpected ways. This could cause investments, financings and hedging strategies to perform differently than management had planned. Income levels could vary significantly from projections and equity could be impaired.
  • Conflicts of Interest - Many mortgage REITs have external managers that may have conflict of interest with other affiliates of the manager. Examples of these potential conflicts are competition for incremental investment opportunities and management attention.
  • Pre-Payment Risk - Mortgage REITs manage their investments with the expectations that it will receive cash flow in the form of principal and interest. If interest rates are declining these cash flows will increase as mortgage holders will look to refinance into lower rate mortgages. The REIT will then be forced to reinvest these proceeds in lower yielding securities. In a rising rate environment, these cash flows may be slower than expected. In this case the REIT is forced to hold on to lower yielding investments and can not reinvest at the now higher rate.
  • Counter-Party Risk - Mortgage REITs rely on counter-parties for financing through repurchase agreements and interest rate swaps. Failure of a counter-party to honor its obligations could have a negative impact on results and operations.
  • Style Drift - Management teams typically are clear in their investment strategy, such as agency only, hybrid residential or hybrid. Failure to stick to the strategy could significantly change results. Additionally, management may employ more or less leverage than expected.
  • Regulatory Risk - In the summer of 2010 Congress passed and the President signed the Dodd-Frank Wall Street Reform and Consumer Protection Act. There is language in the bill that could make it more difficult to securitize assets. With the Republicans now controlling the House, we expect that there will be significant changes to the bill and are unable to quantify any risks. Also, Congress will attempt to pass some form of GSE reform in the current session.
  • Credit Risk - Some mortgage REITs choose to invest in securities that are not guaranteed by the GSEs such as Fannie Mae (FNMA/Unrated), Freddie Mac (FMCC/Unrated) and Ginnie Mae. These assets carry default risk and could negatively impact a company's book value.
  • GSE Reform - We expect Congress to address GSE reform in the current session. While we do not expect the US Government to remove its guarantee on the GSE debt, the structure of the GSEs will likely change. Additionally, the guarantee fee charged by the GSEs could be increased, which would have a negative impact on spreads.
  • Lean organizational Structure - While it is a positive that the companies are very efficient, it can also be a negative as they are very reliant on only a few people. There may be one or two Chief Investment Officers and a handful of analysts deploying capital and managing the portfolio.
  • Shareholder Dilution - As REITs are required to pay the majority of their earnings to shareholders in the form of dividends, growth is typically achieved through additional issuances of equity. If this is done at or below book value, it could lower book value for existing shareholders.

This is a very basic model. As we will discuss later, there are many different variations of mortgage REITs that will dictate the yield on the portfolio, the costs of borrowing and the debt to equity ratio. This shows the power of leverage. Assume that you have $10 million to invest in MBS. If you do not lever your portfolio, you will by $10 million earning 5% and earn $500,000 for a 5% return. By levering the portfolio you would borrow $60 million and purchase $70 million in MBS. You would earn $3.5 million ($70 million x 5%) and owe $1.8 million ($60 million x 3%). Your profit will be $1.7 million and the return will be 17%. Using leverage allows you to earn an additional $1.2 million on your portfolio.

As we said, the above model is very basic. Managers can vary significantly in their use of hedging techniques and the duration of their assets and liabilities. Managers that choose to invest in shorter duration assets trade yield for the ability to reinvest at potentially higher rates. Managers that invest in longer duration assets benefit from the higher yield, but are at risk to the underlying asset declining in value if rates rise. Furthermore, some managers fund their purchases with very short term financing sources while others choose to lock in more expensive, but longer term financing.

Mortgage REITs can be either internally or externally managed. Internally managed REITs are run by employees of the REIT. An externally managed REIT contracts with a manager to run the portfolio. This manager is paid a percentage of equity as a fee to run the portfolio. The fee is typically 1.5% annually and may move downward on a sliding scale as certain equity levels are reached.

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Brokerage and Investment Services are offered through Ladenburg Thalmann & Co. Inc. Member NYSE, NYSE Amex, FINRA and all other principal exchanges. Member SIPC. Ladenburg Thalmanns parent company, Ladenburg Thalmann Financial Services Inc., is traded on the AMEX under symbol LTS.


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Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Investors must make their own determination as to the appropriateness of an investment in any securities based on their specific investment objectives, financial status and risk tolerance. This information is without regard to specific investment objectives, financial situation and particular needs of any specific recipient of this information.