Sept. 14, 1960 REITs are created when President Eisenhower signs into law the REIT Act title contained in the Cigar Excise Tax Extension of 1960. REITs were created by Congress in order to give all investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate.
The earliest mortgage REITs were construction loan REITs that were formed by several major banks in the 1960s and 1970s. These construction loan REITs, most notably the Chase REIT, went bankrupt in spectacular fashion in the mid-1970s. More than a dozen other REITs went bankrupt during this period. I’ve covered this in detail in the past few weeks, the 1970’s were wild and almost every Mortgage REIT went down, closed or went bankrupt. During the next 40 years, bankruptcy came to many REIT’s as read as follows:
The next wave of mortgage REITs began with Strategic Mortgage Investment, Inc. (“SMI”), a Genstar Mortgage Corporation-sponsored residential mortgage REIT, in 1982. SMI’s strategy was to originate non-conforming mortgage loans and sell a 90% senior interest in the loan to investors while retaining a 10% subordinated interest. SMI obtained a private letter ruling from the Internal Revenue Service (“IRS”) that, so long as it sold its senior interest for par, there would be no gain recognized on the sale. SMI was followed by a number of other mortgage REITs, all aimed at the same niche: non-conforming mortgages. Each received its own IRS private letter ruling. These REITs included a REIT sponsored by Countrywide, which later became Indy Mac REIT (and then Indy Mac Bank). They also included Capstead Mortgage Corporation, among others. The rulings these REITs received were later revoked by the IRS in 1985 after the IRS reconsidered the technical basis for the rulings. In response, rather than selling senior participations, mortgage REITs began to adopt a different strategy beginning with the Countrywide REIT.
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The Countrywide REIT would originate residential mortgage loans and then sell them at cost to a taxable subsidiary. The subsidiary would securitize the loans. In this way, profit from securitizing the loans was not earned at the REIT level and no prohibited transaction tax was triggered. Around the same time, the Countrywide REIT began to issue collateralized mortgage obligations (“CMO”s) directly out of the REIT. These transactions were treated as borrowings rather than sales for federal income tax purposes, resulting in no gain (and, again, no prohibited transactions tax).
In the Tax Reform Act of 1986, Congress enacted the Real Estate Mortgage Investment Conduit (“REMIC”) legislation. REMIC is a pass-through vehicle designed to facilitate mortgage loan securitization. Congress wanted REMIC to be the sole vehicle for securitizing multiple-class mortgages. Congress also decided to treat REMIC transactions as sales for federal income tax purposes. This meant that a REIT securitizing mortgages through REMIC could potentially be subject to a 100% prohibited transactions tax on any gain realized on the sales. However, Congress provided a path for REITs to securitize mortgages. Instead of using REMIC, the REIT issues mortgage backed securities that are treated as debt for federal income tax purposes, an “old style” CMO. The chief consequence, however, is that residual income from the CMO when paid to REIT shareholders is treated as “excess inclusion income”, which cannot be offset by the shareholder’s net operating losses.
In the 1990s, mortgage REITs boomed. Large REITs, such as American Home Mortgage, Impac, and others, created successful businesses originating and securitizing residential and commercial mortgages. A few REITs suffered in the mid-1990s, including, for example, Mortgage Realty Trust, which filed for bankruptcy in 1995, and Crimi Mae, which filed for bankruptcy in 1998.
Beginning in early 2007, mortgage REITs once again began to feel the heat. The financial crisis wiped out an entire segment of these REITs, which, in general, were in the business of subprime lending. These bankrupt REITs included, for example, American Home Mortgage Investment Corp., New Century Financial Corporation, and People’s Choice Financial Corporation, among others.
The new crop of mortgage REITs generally have one of three investment strategies, with some overlap amongst the three: those modeled primarily after Annaly Capital Management Mortgage (e.g., Cypress Sharpridge and Invesco), those that primarily acquire, originate and manage mortgages (e.g., Colony Financial and Apollo) and those that primarily target distressed debt with the intent to workout (e.g.,PennyMac).
In the Annaly model, the REIT acquires government backed mortgage securities and other high-quality mortgage securities with leverage. The mortgage securities are good REIT assets, and the REIT earns an arbitrage spread. The assets are residential mortgage-backed securities (“RMBS”), and in some cases, commercial mortgage-backed securities (“CMBS”). The second type of mortgage REIT both acquires and originates residential or commercial mortgage loans. It uses a TRS for its non-qualifying activities. These REITs may securitize the mortgages to enhance returns. The third type of mortgage REIT is the REIT that invests in distressed mortgages. This can be somewhat tricky for a REIT because of what are called the foreclosure property rules. In general, a REIT can foreclose on a mortgage and, for a temporary period, can earn income on the foreclosed real estate which can pass through to shareholders. The REIT, however, cannot take advantage of the foreclosure property rules if it has acquired the mortgage with an intent to foreclose. Accordingly, these REITs will have to make decisions about which mortgages to purchase.