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A move by regulators to review rules governing real estate investment groups in the US has sparked concerns over an important source of mortgage funding.
The Securities and Exchange Commission is looking at whether Real Estate Investment Trusts, or Reits, should enjoy a special status that has allowed them to take more risk than typical investment funds.
Reits, which borrow money in short-term markets to buy mortgages and mortgage-backed securities, have become a pillar of US mortgage finance as restrictions on banks and Fannie Mae and Freddie Mac’s capital have tightened.
Their shares had been outperforming equity markets, thanks in part to their widening dividend yield premium over Treasuries. The Bloomberg Mortgage Reit index yields 14.8 per cent, versus 2 per cent on 10-year Treasuries.
But the shares have lost their lustre following the SEC’s announcement earlier this month that it was to look at the status of Reits. The Bloomberg Mortgage Reits index gained 2.3 per cent in August, against the broader S&P 500 index’s 5.7 per cent decline. The Reits index has erased that gain so far in September, falling 2.2 per cent.
The SEC said the exclusion of Reits from rules for typical funds, including limits on borrowing, could raise the potential for abuses “such as deliberate misvaluation of the company’s holdings, extensive leveraging and overreaching by insiders”.
Rich Moore, analyst at RBC Capital Markets, said that the risks from new rules included eliminating some of the tax advantages of Reits. “The issue is front and centre for the sector,” he said.
Chris Flanagan, head of US structured finance research at Bank of America Merrill Lynch, said that a sharp decline in Reits’ share prices would impair their ability to borrow and could decrease the leverage available to buy mortgages. “The impact on the mortgage market could come if the steady demand from Reits slows down,” he said.
The SEC is currently collecting comments on its proposal. Dozens of retail investors have written in to oppose any changes, though funds and members of the industry have yet to comment.
Analysts at FBR Capital Markets said they expected regulators to make sure any rules did not slow the buying of mortgages. “[The SEC] does not want to prevent the formation of capital,” they said.
Since the beginning of 2010, Reits buying agency mortgages have raised $15bn via equity offerings, according to Bank of America Merill Lynch. Some $200bn of the roughly $5,000bn agency mortgage market is owned by Reits.
Michael Farrell, chief executive of Annaly Capital Management, the largest US mortgage Reit, said: “We support the establishment of a clear and comprehensive set of best practices ... to preserve [Reits’] traditional role in capital formation for residential housing.”