SEC Action Threatens Already Shaky Housing Market
Mortgage real estate investment trusts (“MREITs”), which provide much needed liquidity to a capital starved real estate market, are at risk of losing a key exemption under the Investment Company Act of 1940 (the “Act”). MREITs are currently exempt from the Act and its limits of the amount of leverage a fund can use to acquire assets. The exemption currently allows MREITs to use high levels of leverage to boost returns. Many MREITs use low-rate, short-term bonds to finance bond purchases. If MREITs become subject to the Act, an important source of liquidity for the housing and real estate markets could be lost.
On August 31, 2011, the Securities and Exchange Commission issued concept release IC-29778 (PDF) seeking comments from the public as to whether MREITs, should remain exempt from the Investment Company Act of 1940 (the “Act”) pursuant to Section 3(c)(5)(C) of the Act. The public comment period for the concept release ended on November 7, 2011.
The SEC’s stated goals in issuing the concept release (PDF) are to: “(1) be consistent with Congressional intent underlying the exclusion from the Act provided by Section 3(c)(5)(C); (2) ensure that the exclusion is administered in a manner that is consistent with the purposes and policies underlying the Act, the public interest, and the protection of investors; (3) provide greater clarity, consistency and regulatory certainty in this area, and (4) facilitate capital formation.”
Under Section 3(c)(5)(C) of the Act, any person “not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates and who is primarily engaged in one or more of the following businesses . . . (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate” is not an investment company for purposes of the Act. MREITs have little in common with traditional property REITs aside from satisfying REIT requirements that 75% of the MREIT assets be real estate related and 90% of taxable income is returned to investors as dividends.
According to the National Association of Real Estate Investment Trusts (“NAREIT”), there were 29 publicly traded MREITs with a combined equity market capitalization of $43 billion. MREITs provide critical financing and liquidity in the real estate capital markets by funding mortgage related residential and commercial loans, originating mortgages and mortgage related loans. (See NAREIT comments to SEC.) As we have seen, credit markets have tightened significantly since the financial crisis and the burst of the housing bubble. Fannie Mae and Freddie Mac have required billions in taxpayer bailout dollars to remain marginally solvent while many in Washington call for the winding down of all government sponsored entities. According to the Mortgage Bankers Association (“MBA”), MREITs have stepped in to fill a portion of the credit void. MREITs have “raised over $30 billion of capital in 88 initial public offerings and secondary offerings since 2008” and have raised another “$11 billion in the first part of 2011 alone which translates into $71 billion of mortgage demand out of a net supply of $203 billion.” (See MBA Comments to SEC).
The SEC’s focus on the leverage that MREITs use to acquire assets seems terribly misplaced. With an average leverage of 8-1, MREITs can lock in spreads of 200 basis points and produce yields in the mid-teens. When compared to mortgages held by banks, the 8-1 leverage is tame in comparison. When a bank holds a mortgage that is not guaranteed by Fannie Mae or Freddie Mac, the bank is required to hold 8% capital in reserve, or an 11.5 to 1 leverage. When those mortgages are guaranteed by Fannie and Freddie, the credit reserve requirement is cut by 80% resulting in a more than 60-1 leverage. At a time when the real estate market, particularly housing, is starved for capital, freezing out an important player is ill-advised and inconsistent with the SEC’s stated goals in issuing the concept release.