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© 2009 Morrison & Foerster LLP All Rights Reserved
Real Estate Investment Trusts
Anna T. Pinedo, Morrison & FoersterThomas A. Humphreys, Morrison & FoersterHalle Benett, UBS Investment Bank
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Why a REIT?
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Real Estate Investment Trusts
• A REIT is an investment vehicle designed to allow investors to pool capital to invest in real estate assets
• Publicly traded investment vehicle
• Pass-through entity for U.S. federal income tax purposes
• Can be classified into three categories: • Equity REITs• Mortgage REITs• Hybrid REITs
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Real Estate Investment Trusts
• Equity REITs• “Real” REITs that directly own, invest in, or acquire, manage, or
develop real property• Derive revenue from income generated by rents• Include shopping mall, apartment complex, commercial office,
hotel and other similar REITs
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Real Estate Investment Trusts
• Mortgage REITs• Invest indirectly in real property through investments in
mortgages, CMBS, RMBS, etc. • Generate income from interest earned
• Hybrid REITs• A combination of equity and mortgage interests in properties
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Real Estate Investment Trusts
• Capital Structure• Equity
• Common
• Preferred
• Debt• Subordinated
• Senior
• Management• Internal • External
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Why Invest in REITs
• Access• Provides retail investors with an opportunity to participate in real
estate investments
• Tax advantages
• Highly liquid
• Dividend-paying
• Professionally managed
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Mortgage REITs
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History of Mortgage REITs
• Construction loan REITs formed by several major banks in the 1960s and 1970s• Example: Chase REIT• Made loans to developers, other real estate owners• When the real estate market went into a downturn, many
construction loan REITs went bankrupt in the mid-1970s as the loans soured
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History of Mortgage REITs
• Next wave of mortgage REITs began cropping up in the 1980s• Examples: Strategic Mortgage Investments, Inc., Countrywide
REIT, Capstead Mortgage Corporation • Mortgage REITs sold off the 90% senior interests in loans
originated by the REIT while retaining a 10% subordinated interest. IRS granted PLRs allowing nonrecognition on the sale of senior interests. PLRs later revoked after reconsideration of technical issues.
• Mortgage REITs shifted to borrowings through CMOs. CMOs were treated as borrowings rather than sales for US federal income tax purposes.
• 1986 Act created “REMIC”s, intended to be the sole vehicle for securitizing mortgages. REITs may also securitize mortgages (old-style CMOs), but limitations exist on “excess inclusion income”
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History of Mortgage REITs
• 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.
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History of Mortgage REITs
• During the early 2000s, many mortgage REITs expanded into subprime lending.
• Beginning in early 2007, such mortgage REITs began to feel the heat. The financial crisis wiped out an entire segment of these REITs.
• Examples: American Home Mortgage Investment Corp., New Century Financial Corporation, and People’s Choice Financial Corporation, among others.
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Today
• At least 14 mortgage REITs have filed registration statements to raise capital in the last several months
• General Investment Strategies• Invest in high quality securities• Originate mortgage loans • Invest in distressed debt
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REIT Market Update
Note: Market Data as of October 30, 2009
Mortgage Finance
Price Change Price/EPS Price/
Company Ticker
Share Price
($)
Market Cap
($mm) LTM (%)
YTD (%)
3 Month (%)
1 Week (%)
2009E (x)
2010E (x)
Book (x)
Tang. Book (x)
Dividend Yield (%)
Long-Term EPS Growth
(%)
Non-Agency REITs
Chimera Investment Corp. CIM 3.49 2,339 10.8 1.2 (2.5) (11.0) 7.8 6.5 1.07 1.07 9.2 5.0
Redwood Trust Inc. RWT 13.94 1,080 (0.2) (6.5) (14.2) (5.2) 46.5 7.6 1.35 1.35 7.2 5.0
PennyMac Mortgage Investment PMT 18.41 308 na na (2.1) (2.5) 73.6 6.1 0.92 0.92 na 10.0
Invesco Mortgage Capital Inc. IVR 19.94 199 na na (0.3) (2.0) 14.6 6.2 1.02 1.02 – 4.0
Median—Non-Agency REITs 5.3 (2.7) (2.3) (3.9) 30.5 6.3 1.04 1.04 7.2 5.0
Agency REITs
Annaly Capital Management NLY 16.91 9,347 21.1 6.6 0.4 (3.1) 6.2 5.8 1.02 1.03 14.2 5.0
MFA Financial Inc. MFA 7.42 1,651 37.4 26.0 0.3 (3.5) 6.9 5.9 1.06 1.06 11.9 3.0
Hatteras Financial Corp. HTS 28.10 1,017 32.0 5.6 (0.8) 1.5 5.8 5.6 1.08 1.08 15.7 5.0
Capstead Mortgage Corp. CMO 13.16 909 34.3 22.2 (1.5) (0.4) 5.7 5.5 1.07 1.07 17.6 4.5
Anworth Mortgage Asset Corp. ANH 7.13 742 28.9 10.9 (5.4) (7.6) 5.8 5.5 0.97 0.97 18.0 1.0
American Capital Agency Corp. AGNC 26.00 502 44.4 21.7 14.1 (9.5) 4.3 5.5 1.17 1.17 23.1 5.0
Cypress Sharpridge Investments CYS 13.35 242 na na 0.8 (1.0) 5.8 5.3 0.98 0.98 – na
New York Mortgage Trust Inc. NYMT 6.08 57 211.8 176.4 3.1 (21.3) 5.7 4.5 1.24 1.24 15.1 na
Median—Agency REITs 34.3 21.7 0.3 (3.3) 5.8 5.5 1.07 1.07 15.4 4.8
Overall Median 32.0 10.9 (0.6) (3.3) 6.0 5.7 1.06 1.07 14.2 5.0
Overall Mean 46.7 29.3 (0.7) (5.5) 15.7 5.8 1.08 1.08 12.0 4.8
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REIT Market Update
Mortgage Finance
Note: Market Data as of October 30, 2009
Price Change Price/EPS Price/
Company Ticker
Share Price
($)
Market Cap
($mm) LTM (%)
YTD (%)
3 Month (%)
1 Week (%)
2009E (x)
2010E (x)
Book (x)
Tang. Book (x)
Dividend Yield (%)
Long-Term EPS Growth
(%)
Commercial Mortgage REITs – 2009 IPOs
Starwood Prop Trust Inc. STWD 20.13 979 na na na (0.9) nm 9.9 nm na na 10.0
Colony Financial Inc. CLNY 19.45 285 na na na (2.0) na na na na nm na
CreXus Investment Corp. CXS 14.18 253 na na na (1.0) na na nm na na na
Apollo Comm Real Estate Fin ARI 17.91 188 na na na (2.3) na na nm na na na
– Median – 2009 IPOs – – – (1.50) – – – – – 10.00
Commercial Mortgage REITs – Pre 2009 IPOs
NorthStar Realty Finance Corp. NRF 3.53 241 (35.7) (9.7) (1.4) (1.4) 4.9 nm 0.19 na 11.3 na
iStar Financial Inc. SFI 2.09 208 81.7 (6.3) (14.0) (22.3) nm nm 0.14 0.15 – –
Gramercy Capital Corp. GKK 3.14 157 110.7 145.3 118.1 12.1 nm nm 0.21 0.57 – na
Newcastle Investment Corp. NCT 1.92 102 (52.6) 128.6 195.4 (16.5) na na nm nm – na
Anthracite Capital Inc. AHR 0.72 57 (79.2) (67.7) 24.1 (13.3) 4.1 nm 0.16 0.16 – na
Arbor Realty Trust Inc. ABR 2.00 51 (42.4) (32.2) 10.5 (18.0) nm nm 0.19 0.19 – na
Capital Trust Inc. CT 1.96 43 (71.9) (45.6) 23.3 (18.3) nm nm 0.13 0.13 – na
JER Investors Trust Inc. JRT 0.55 3 (98.1) (94.1) 48.6 (3.5) na na 0.16 0.16 – na
Realty Finance Corporation CRTYZ na na na Na na na na na na na na na
Median – Pre 2009 IPOs (62.2) (38.9) 36.4 (15.9) 4.1 – 0.16 0.16 – –
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Historical Valuations
Price to NTM Earnings—Last 10 Years Dividend Yield—Last 10 Years
Note:
1 Median includes Annaly Capital, Anworth Mortgage, Capstead Mortgage, MFA Financial and Redwood Trust
Source: FactSet
REIT Median¹
10 yr Avg: 9.2x
6.0x
0.0
5.0
10.0
15.0
20.0
25.0
30.0
1999 2001 2003 2005 2007 2009
(x)
13.5%
10 yr Avg: 10.2%
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
1999 2001 2003 2005 2007 2009(%
)
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Historical Valuations
Price to Book—Last 10 Years
Note:
1 Median includes Annaly Capital, Anworth Mortgage, Capstead Mortgage, MFA Financial and Redwood Trust
Source: FactSet
10 yr Avg: 1.10x
1.02x
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00
1999 2000 2002 2003 2004 2005 2006 2007 2008 2009
(x)
REIT Median¹
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REIT Registrations
REITs Currently in RegistrationInitial Filing Date
Current Filing Date Issuer
Deal Value ($mm) Manager Asset Class Focus
Incentive Fee?
8/28/09 8/28/09 Marathon Real Estate Mortgage Trust 300 Marathon Asset Management Residential Yes
8/28/09 10/21/09 Brookfield Realty Capital Corp. 500 Brookfield Commercial Yes
7/29/09 9/2/09 Transwestern Realty Finance Inc 500 Transwestern Whole Mortgage Loans & Subordinated Debt
Yes
7/27/09 10/30/09 Bayview Mortgage Capital LLC 500 Bayview Asset Management (Blackstone) Diversified Yes
7/17/09 9/29/09 Ladder Capital Realty Finance Inc 400 Ladder Capital Finance Holdings (UBS DRCM, TowerBrook and GI Partners)
Commercial No
7/14/09 10/08/09 Ellington Financial LLC 200 Ellington Management Group Diversified Yes
7/13/09 7/13/09 AG Financial Investment Trust Inc 300 Angelo Gordon & Co. (GE Capital) Diversified—PPIP Yes
7/08/09 9/18/09 Foursquare Capital Corp 500 AllianceBernstein Diversified—PPIP Yes
6/12/09 10/6/09 Western Asset Mortgage Capital 500 Legg Mason Diversified—PPIP Yes
5/21/09 7/29/09 Sutherland Asset Management Corp 250 Waterfall Asset Management (M.D. Sass—Macquarie)
Residential—Non-Agency MBS No
8/15/08 11/7/08 CWCapital Realty Trust Inc 250 CW Financial Services Commercial Yes
6/04/08 6/04/08 Petra Real Estate Opportunity Trust 200 na Commercial Na
4/25/08 9/22/09 Madison Square Capital Inc 200 Highland Financial Holdings Group Residential—Agency MBS No
2/29/08 5/30/08 Point Asset Management Inc 250 FII Holdings Diversified Yes
2/12/08 5/15/09 MFResidential Investments Inc 250 MFA Mortgage Investments Residential— Non-Agency MBS
No
5/11/07 6/28/07 Marathon Real Estate Finance Inc 200 Marathon Asset Management Commercial No
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Recent REIT IPOs
Note:
1 Gross proceeds including over-allotment option and private placement
Source: Company Filings
IPO Date Issuer Manager
Completed IPO Size ($mm)
Gross Proceeds ($mm) 1 Asset Class Focus Incentive Fee?
9/23/09 Apollo Commercial Real Estate Finance
Apollo Global Management 200
210 Commercial Loans No
9/23/09 Colony Financial Inc Colony Capital 250
293 Commercial Loans Yes
9/16/09 CreXus Investment Corp. FIDAC (Annaly) 200
268 Commercial Loans No
8/11/09 Starwood Property Trust Inc Starwood Capital Group 810
952 Commercial Loans Yes
7/29/09 PennyMac Mortgage Investment Trust
PNMAC Capital Management (BlackRock, Highfields)
320
335 Residential—Distressed Loans Yes
6/25/09 Invesco Mortgage Capital Inc. Invesco Ltd. (NYSE: IVZ) 170
206 Diversified—PPIP No
6/11/09 Cypress Sharpridge Cypress Sharpridge Advisors LLC 100
115 Residential— Agency MBS No
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Tax Requirements
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Taxation of REITs
• Requirements: Section 856(a)• Centralized management • Transferable shares• C Corporation for tax purposes• Not a financial institution or insurance company• Widely held (5 or fewer test, 100 shareholder requirement) • Income and assets tests• Distribution requirements
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Income Test
• At least 75% of a REIT’s gross income must be: • Rents from real property;• Interest on obligations secured by mortgages on real property or
on interests in real property;• Gain from the sale or other disposition of real property (including
interests in real property and interests in mortgages on real property) which is not dealer property;
• Dividends or other distributions on, and gain (other than gain from prohibited transactions) from the sale or other disposition of, shares in other REITs;
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Income Test
• Abatements and refunds of taxes on real property;• Income and gain derived from foreclosure property;• Commitment fees;• Gain from the sale or other disposition of a real estate asset
which is not a prohibited transaction; and• Qualified temporary investment income.
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Income Test
• At least 95% of the REIT’s gross income must be derived from:• Items that meet the 75% income test; • Other dividends; • Other interest; and• Gain from the sale or other disposition of stock or securities that
are not dealer property.
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Asset Test
• At least 75% of the value of the REIT’s total assets is represented by real estate assets, cash and cash items (including receivables), and Government securities (“base securities”).• 25% asset test. Not more than 25% of the value of the REIT’s total
assets is represented by securities (other than base securities).
• 25% asset test. Not more than 25% of the value of the REIT’s total assets is represented by securities of one or more TRSs.
• 5%/10% asset tests: except for TRSs and base securities,• Not more than 5% of the value of the REIT’s total assets is represented by
securities of any one issuer,• The REIT does not hold securities possessing more than 10% of the total
voting power of the outstanding securities of any one issuer, and• The REIT does not hold securities having a value of more than 10% of the
total value of the outstanding securities of any one issuer.
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Distribution Requirements
• The REIT provisions do not apply to an entity for a taxable year unless the deduction for dividends paid during the taxable year equals or exceeds: (i) the sum of (a) 90% of the real estate investment trust taxable income for the taxable year (determined without regard to the deduction for dividends paid and by excluding any net capital gain); and (b) 90% of the excess of the net income from foreclosure property over the tax imposed on such income by Code Section 857(b)(4)(A) minus (ii) any excess noncash income.
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Prohibited Transactions Tax
• A REIT is subject to a 100% tax on net income derived from prohibited transactions.
• Prohibited transaction means a sale or other disposition of dealer property.
• Dealer property is: “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”
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Taxable REIT Subsidiary
• A REIT may enter into otherwise prohibited activities through a TRS.
• The TRS itself is taxable as a corporation. • For purposes of the asset tests, 25% of a REIT’s assets
can be held in TRSs. • With respect to the income tests, the Code allows the
TRS to perform noncustomary services which would otherwise not qualify as good income.
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Foreclosure Property
• Income and gain from foreclosure property is good income for both income tests even if it would not otherwise qualify as good income. Thus, the income cannot disqualify the REIT. However, the price for this protection is that the REIT is subject to tax at regular corporate rates on income from foreclosure property that does not otherwise qualify as good income under the 75% income test.
• Foreclosure property means any real property (including interests in real property), and any personal property incident to such real property, acquired by a REIT as the result of such REIT having bid in such property at foreclosure, or having otherwise reduced such property to ownership or possession by agreement or process of law, after there was default (or default was imminent) on a lease of such property or on an indebtedness which such property secured. Foreclosure property does not include property acquired by the REIT as a result of indebtedness arising from the sale or other disposition of dealer property not originally acquired as foreclosure property.
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Captive REITs
REIT
Rental Payments
Dividends
A
REIT
Taxpayer
Dividends
B
Assets
Income
Subsidiary
Taxpayer
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Captive REITs
• One use of Captive REITs has historically been to reduce or eliminate state taxes.
• The REIT is not taxed if the state models its tax law after federal law because of the dividends paid deduction.
• The taxpayer also attempts to receive a second deduction in the same or another jurisdiction.
• States have been attacking these structures.
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Corporate and Securities Law Issues
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Formation
• An existing company may reorganize itself in order to qualify as a REIT Reorganization will depend upon the original structure Objective will be to have the company hold “qualifying assets”
and transfer assets that yield non-qualifying income
• A REIT may be organized as a business trust or as a corporation
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Formation
• A new entity may be formed that qualifies as a REIT• Most REITs are organized in Delaware or Maryland• Maryland’s REIT law is the most well formed• The entity’s organizational documents will need to
contain special provisions regarding ownership limits and transfers
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Maryland law
• Maryland has a statute that applies specifically to REITs organized as trusts.
• In Delaware, a REIT is required to “at all times have at least one trustee which, in the case of a natural person, shall be a person who is a resident of this state or which, in all other cases, has its principal place of business in this state.” There is no such requirement in Maryland.
• Maryland limits the liability of trustees and officers for monetary damages in suits by or on behalf of the REIT or by its shareholders. Maryland REIT Law permits a trust REIT to indemnify and advance expenses to its trustees and officers to the same expansive extent permitted for directors and officers of Maryland corporations.
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• Maryland permits trustees, without shareholder approval, to amend the declaration of trust to cause a trust REIT to continue to qualify as a REIT under the Internal Revenue Code.
• The Maryland Business Combination Act (which includes a five-year moratorium on transactions with an interested stockholder, and supermajority vote requirements for business combinations thereafter) applies to a Maryland REIT, unless it opts out of the statute. The Maryland Control Share Acquisition Act also includes REITs and is believed to have the lowest trigger (10%) of any state control share acquisition statute.
Maryland law (cont’d)
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Organizational issues
Historically, REITs have been structured in any of the following ways:
• as UPREITs (umbrella partnership)• as Down REITs • as paired-share REITs• as stapled REITs• as paper clip REITs
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UPREIT (Equity)
Newly FormedREIT
Operating Partnership
(L.P.)
Taxable REIT Subsidiary
IPO Cash General Partner
Public Shareholders
Historic Properties New Properties
Limited Partners (former private real estate partnership interest holders)
OP Units (1:1 conversion to REIT shares)
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UPREIT (Mortgage)
REIT
Operating Partnership
(L.P.)
General Partner
Public Shareholders
Mortgages TRS
Limited PartnersOP Units (1:1 conversion to REIT shares)
(REO/“Far Gone” Mortgages)
Structure Permits Future Acquisition of Mortgage Portfolios on a Tax Free Basis (But Would Defer Losses to LPs if Loss Loans)
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DOWNREIT
Existing REITExisting Properties
Existing and Contributed Properties
Contribution
Mortgages TRS
Limited Partners
(REO/“Far Gone” Mortgages)
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The Paired-Share REIT Structure
REIT Lessee Operator
Fee Simple Ownership in
Property(e.g., Racetrack)
Paired Shares Trade as Unit
Operating Income
Lease
Rents
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External versus internal management
• External management structure usually resembles a private equity style arrangement manager receives a flat fee and an incentive fee most incentive fees for external managers are structured with a
high water mark
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SEC Filings
• In order to file with the SEC for an initial public offering, a REIT will prepare and file a registration statement on Form S-11
• The S-11 requirements differ from those for Form S-1• In addition, REIT issuers also must consult SEC Industry
Guide 5
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40 Act Exemption
• A REIT may qualify for an exemption under section 3(C)(5)(C) of the Investment Company Act of 1940 (the “40 Act”): Available for entities primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and interests in real estate;
Generally applies if at least 55% of the REITs assets are comprised of qualifying assets and at least 80% of its assets are comprised of qualifying assets and real estate-related assets.
For these purposes, qualifying assets generally include mortgage loans and other assets which are the functional equivalent of mortgage loans.