REITs and MBS

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					REITs and MBS
Juerg Syz
University of Zurich
FS 2012
                            Agenda


1.  Real Estate Investment Trusts (REITs)

2.  Mortgage Backed Securities (MBS)

3.  The subprime crisis




                                            2
                  Real Estate Investment Universe

                                  Real Estate Investments


                Listed / Traded                                Non-Listed


    Real Estate              Real Estate               Direct /              Private (Equity)
      Equity                   Debt                   Consortium            Real Estate Funds
• REITs                   • MBS                    • Equity                 • Core / Value-Added
• RE Companies            • Mortgage Fund/REIT     • Mezzanine Loan         • Opportunistic
• RE Funds                • Shares of Mortgage     • Bridge Loan            • Private RE Debt
• Property Derivatives      Banks                  • Mortgage                 Funds




     Indirect
                                                                                               3
                            What are REITs

Real estate investment trusts (REITs) are investment vehicles that invest in a
diversified pool of professionally managed real estate assets.

  Relatively passive investment in a pool of real estate assets
  Steady rental stream
  Potential for capital growth
  Tax-efficient yield (flow-through taxation)
  Way for investors to invest in real estate without the large capital outlay
  Diversification benefits
  Typically structured as a trust or corporation
  Listed and traded on a stock exchange
  Externally or internally managed

                                                                                 4
                       Three Main Benefits

• Flow-through taxation: as long as the REIT meets certain requirements
  under the various tax laws, investors can benefit from “flow-through”
  taxation, in which the REIT is not taxed on its income and tax is paid only
  once in the hands of investors.

• Greater liquidity and capital flexibility: investors are able to get exposure
  to the capital growth and income stream of the underlying assets without
  large capital outlay. It also allows investors to benefit from greater liquidity
  as compared with investing in the real underlying assets.

• High yield: typically, the main attraction of REITs is their yield. REITs
  usually have high payout ratios that are either mandated in REIT codes or
  are incentivized by taxation requirements.


                                                                                 5
                REIT Status Requirements


Maximum leverage                 Typically 30% to 50%,
                                 up to 70% if rated, sometimes unlimited

Distribution / dividend payout   Typically 90%

Assets                           No development or other assets

Governance                       Strict codes to avoid conflicts of interest
                                 (fee structure, related-party transactions,
                                 disclosure, etc)



                                                                               6
               Management and Governance

REIT sponsor            Sources the initial properties at the time of listing,
                        motivation to divest properties into a REIT is to
                        recycle capital and raise funds

REIT manager            Usually onwed by the sponsor (external) or the
                        REIT (internal); performs operations, financing,
                        and property management

Trustee (e.g. a bank)   Responsible for holding the properties in trust
                        for unitholders; perform due diligence to protect the
                        rights and interests of unitholders

Trust deed              Agreement between manager and trustee; governs
                        the way the REIT is legally organized and managed
                                                                                 7
         Internally vs Externally Managed

Externally managed             versus   Internally managed



- RE Funds                              - RE Companies
- REITs (standard)                      - REITs (exceptions, e.g. AU)



Conflict of interest between            Conflict of interest avoided
unitholders (principals) and            (manager owned by REIT)
managers (agents)




                                                                        8
           Externally Managed REIT Structure

                                                   Unitholders


            Sponsor                     Holds Units /       Distributions
                                        Shares in REIT
Wholly / Partly
       Owned
                                                                  Holds Properties on
                             Management Services                  Trust for Unitholders
            Manager                                  REIT                                 Trustee
                               Management Fee                        Truestee‘s Fee


                                                            Distributable Income


                                                   Properties

                   Equity Interest
                   Services
                   Flow of Funds

   Source: CFA Institute                                                                            9
                The Global REITs Market




Market Size
North America   about USD 250 bn
Europe          about USD 100 bn
Asia-Pacific    about USD 250 bn

Source: CBRE
                                          10
             Evolution of the Global REIT Market




Source: Association of Real Estate Securitization and CFA Institute
                                                                      11
                   Valuation of REIT shares

Basically, three methods to value REIT shares (Geltner / Miller)

1.  Dividend Discount Method (Gordon Growth Model, DCF)
     Share price as the PV of expected cash flows

2. Earnings- and Cash Flow-Multiples (Shortcuts to DCF)
     Share price as a multiple of earnings or CF

3. Premium/Discount to Net Asset Value (NAV)
     Share price of public REIT based on private market value of the
    property portfolio, adjusted for growth opportunities




                                                                        12
          Valuation: Dividend Discount Method
Determining Sustainable Earnings and Dividends

Net Operating Income (NOI)
+ Depreciation (added back)
- Gains from Property Sales
-  CapEx

≈ AFFO (Adjusted Funds From Operations)




 AFFO is a good cash flow measure of a REIT’s earnings and dividend-paying capacity
  Dividend (DIV) is smaller than AFFO if earnings are retained (plowback p)
  Price-to-AFFO is often used as a comparable multiple


                                                                                 13
                    CF: Earnings or dividends?

The direct capitalization can be applied either to dividends or to AFFO:



                DIV   AFFO
             V=     =        , DIV < AFFO, g > gV
                r"g   r " gV
The opportunity cost of capital r is the same, but be careful about the growth rate:

g
! = Dividend growth, includes the effects of reinvested earnings (plowback effect)
gV = Long-run growth rate in current assets’ earnings




                                                                                       14
                         Determination of gV
What is the relationship between g and gV`?


DIV1 = (1-p) AFFO1 = (1-p) y V0, where:
y = earnings yield for the REIT’s assets (≈ AFFO/V)
V0 = REIT’s asset value today


DIV2 = (1-p) y V1
     = (1-p) y [(1+gV) V0 + p y V0]
     = (1-p)y (1+gV+p y)V0
     = (1+gV+p y) DIV1

à g = gV + p y
                                                      15
                    Valuation: What is NAV?

Net Asset Value =    REIT Assets Value (as valued in property market)
                     – REIT Liabilities
                     ÷ Number of Shares Outstanding



Potential reasons for the difference between NAV and share price
(so-called premium/discount)

  Stock market vs. property market valuation differential
  Stock value – NAV = NPV of growth opportunities (market implied)
  Errors or omissions in the NAV estimation process


                                                                        16
 Post-Crash Valuation: Listed vs. Private




Source: CBRE
                                            17
 Post-Crash Valuation: Listed vs. Private




Source: CBRE
                                            18
Mortgage-backed Securities
                    RE Mortgage Markets

Fundamental difference between US and European mortgage markets:
•  US banks rely on the capital market to finance mortgages
•  European banks rely mostly on deposits

EU: Less than 4% of mortgages are financed through capital markets
  Estimated only EUR 250 billion
  Concentrated in Germany with 44%, Denmark with 29% and Sweden with
  15% of the market size

US: highly liquid market for Mortgage-Backed Securities (MBS)
USD 14’200 billion of total US mortgage debt
USD 8’900 billion of total US mortgage-related securities (63%!)
USD 5’000 billion guaranteed by government sponsored enterprises
                                                                   20
                       MBS: Securitization

1. Mortgage loans are purchased from banks and other lenders
2. The loans are assembled into collections, or trusts
3. These trusts securitize the mortgage pool and issue mortgage-backed
    securities, with documentation that identifies the underlying loans

   Residential mortgage-backed securities (RMBS) are secured by single-
   family homes

   Commercial mortgage-backed securities (CMBS) are secured by
   commercial and multifamily properties




                                                                          21
                         Structure of MBS

Base Case: “Pass-through” securities
•  Issue undifferentiated securities (small homogeneous units) on the pool
•  Each unit receives its pro rata share of all the cash flow coming from the
   pool (interest payments, principal payments, prepayments)

PO and IO strips
  The Principal Only (PO) and Interest Only (IO) strips is a device to protect
  investors against the prepayment risk. Mortgage investors compute their
  yield on a predicted prepayment speed which is usually based on models. If
  a prepayment takes place, it affects the future interest stream. The principal
  is repaid anyway in full.



                                                                                22
      Collateralized Mortgage Obligation (CMO)
A CMO is a more complex MBS in which the mortgages are ordered into tranches,
with each tranche sold as a separate security (not a pass-through structure)

                                                      Assets        Investor Classes

•  The senior tranche (class A) is paid off first
   and is thus most senior (most secure)
                                                                    Senior Tranche
•  The mezzanine tranche only is paid after
   the senior tranche is satisfied
                                                    Mortgage Pool
•  The equity tranche is paid last and hence
   serves as credit-enhancement                                       Mezzanine
                                                                       Tranche


                                                                    Equity Tranche

                                                                                       23
      Collateralized Mortgage Obligation (CMO)
Redistribution of losses: buying and selling insurance

                                                     1

                                                    0.9

                                                    0.8
            expected loss in percent of principal




                                                    0.7

                                                    0.6
                                                              equity tranche




                                                    0.5
                                                                               mezzanine tranche




                                                    0.4

                                                    0.3
                                                                                                          senior tranche




                                                    0.2

                                                    0.1                                                                        sell insurance
                                                                                                                               buy insurance
                                                     0
                                                          0                    0.2                    0.4            0.6             0.8        1
                                                                                                   percent of aggregate loss
                                                                                                                                                    24
      Collateralized Mortgage Obligation (CMO)
What factors affect the pricing?

•  Granularity                                    1
                                                                                                            normal correlation
•  Correlation                                   0.9
                                                                                                            high correlation
                                                                                                            low correlation
•  Spread (and spread balance)
                                                 0.8


                                                 0.7


                                                 0.6
                                 Expected Loss



                                                                  High correlation favors the equity tranche
                                                 0.5              Low correlation favors the senior tranche
                                                 0.4


                                                 0.3


                                                 0.2


                                                 0.1


                                                  0
                                                       0   0.1   0.2   0.3   0.4      0.5      0.6   0.7   0.8      0.9          1
                                                                             Continuous "Tranches"
                                                                                                                          25
      Collateralized Mortgage Obligation (CMO)
Thanks to the credit enhancement, the senior tranche gets a much better
rating than the overall pool: it is only affected by losses after all other
tranches are completely eaten up!



This structure enabled a “new financial alchemy”
Turning a pool of bad or mediocre loans into 80% of AAA-rated bonds and
20% unrated high-yield tranches.

Let’s look at what exactly happened during the subprime crisis.




                                                                              26
The Subprime Crisis




                      27
       The US subprime crisis chain of events

Housing Market
•  Starting in the late 90ies, a loose monetary policy made debt financing attractive
•  Housing programs for low-income borrowers required virtually no home equity
•  The result, as intended: a significant increase in housing affordability
•  As a consequence of the increased demand, prices began to rise
•  Builders were prompted to construct more homes, satisfying the excess demand
•  In 2005, housing starts were twice as high as in 1990

Mortgage Market
•  Also, as mortgage markets have become more competitive
•  Banks have increasingly used brokers to find borrowers
•  Brokers are incentivized by sales volume and do not take any credit risk
•  The number of brokers rose rapidly, and the way for mispricing was eased

                                                                                        28
        The US subprime crisis chain of events

IB Market
•  Mortgage pool structures were identified to be a profitable business
•  Subprime loans, originated by the brokers, were bundled by mortgage lenders
•  These bundles were passed on as MBS to investment banks
•  The MBS were then used to create collateralized debt obligations (CDOs)
•  About two thirds of all securitized US mortgages were sold to investors
•  The remainder – about USD 3.5 trillion – was kept on the banks’ balance sheets
•  Combined with leverage, these assets boosted banks’ profits and return on equity
•  The RoE of a bank is a performance measure eyed by most analysts



•    In 2006, MBS accounted for more than 20% of all US residential mortgages



                                                                                  29
        The US subprime crisis chain of events

The Tipping Point
•  In 2006, uncontrolled overbuilding led to a surplus inventory of homes
•  Vacancy rates in the residential market rose to almost 3% (1.5% is normal)
•  The excess supply placed downward pressure on prices
•  Refinancing became more difficult, a problem amplified by rising interest rates
•  Lenders re-valued their assets, and mortgage rates were reset at higher levels
•  Borrowers began defaulting, triggering a feedback loop:
      •  The increased number of foreclosed mortgages drove housing prices further down
      •  Lenders needed to re-value their assets and rates again.



•    In 2008, 30% of US homeowners who bought after 2002 had negative home equity



                                                                                          30
            The US subprime crisis chain of events

Everyone Surprised
•  Normally, a property downturn is slow because owners tend to hold on to their home
•  This time, house prices have fallen sharply due to the numerous foreclosure sales
•  The sudden losses were hard to absorb for homeowners and banks

And then it got worse
•  The ultimate MBS investors were disconnected from the ultimate mortgage borrowers
•  Hence investors needed to rely on ratings
•  Rating agencies underestimated the market risk in the complex structures
      •  The more layers in a structured credit vehicle, the more exotic its loss distribution
      •  If 1st layer assumptions are wrong, a 3rd level structure collapses quickly under pressure


•    Recall: the 1st layer (the process of origination) was outsourced to brokers that take no risk


                                                                                                      31
      The US subprime crisis chain of events

Collapse of liquidity
•  Confidence in the ratings and valuations of the vehicles was gone
•  MBS risk premia increased significantly
•  The structures were widely dispersed, no one knew how/which banks were affected
•  These uncertainties were aggravated through the repeated downgrading of ratings
•  The loss of confidence led to a collapse of liquidity in MBS and related markets

   … the rest is history.




                                                                                32

				
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