When the term 'real estate investment trust' or REIT comes up in conversation, most people immediately think of ‘equity REITs’, which own and manage physical properties like malls and office buildings.
However, there's another type of REIT that plays a key but less visible role in the commercial real estate (CRE) ecosystem – ‘commercial mortgage REITs’. Unlike equity REITs, commercial mortgage REITs don't own property. Instead, they provide essential financing for income-generating CRE projects.
How Commercial Mortgage REITs Work
Commercial mortgage REITs act more like a lender than a property owner. Instead of owning actual real estate, they provide financing for income-generating CRE by purchasing mortgages and mortgage-backed assets.
Many of these REITs are publicly traded entities listed on major stock exchanges. They often raise capital from financial markets to fund their CRE projects.
They also offer greater liquidity compared to equity REITs. This is important for investors seeking to quickly buy or sell shares.
As an investor, there are a few important things you need to know about commercial mortgage REITs, which is why we’ve put together this guide.
1. The Role of Commercial Mortgage REITs in Mortgage Origination
Mortgage origination is the initiation of a loan for a commercial property. Since many CRE projects rely on financing to make them a reality, mortgage origination is all-important. Commercial mortgage REITs specialize in this aspect, often stepping in where traditional bank lending falls short.
As such, they provide a financial backbone for a variety of large CRE developments from the construction of new shopping malls to industrial complexes.
They might also provide bridging finance for renovations to existing office buildings. What sets these REITs apart from traditional lenders, is their speed and flexibility.
They can quickly evaluate the viability of a project and provide timely financing which is often a critical factor in CRE deals. While they tend to be more risk-tolerant than traditional lenders, they still expect a competitive return on their investment. To ensure this, they meticulously evaluate the risks associated with each mortgage they originate.
2. Unlocking Liquidity Through Securitization
Property is an illiquid asset because it cannot be sold quickly. This lack of liquidity poses some risks to an investment.
Securitization is the process of taking an illiquid asset, like a property mortgage, and transforming into a more liquid form that can be traded on capital markets like the stock exchange.
These liquid assets are called securities.
This is one way that commercial mortgage REITs buy commercial mortgages to unlock liquidity in the CRE market. In essence, securitization frees up capital that would otherwise be tied up on long-term loans. The available capital can be used to issue more loans without depleting financial reserves.
This process allows for more and also larger CRE projects to be funded. Mortgage REITs help to speed up the cycle of property development by making more money available to CRE investors.
Understandably, risks are involved in this process. These could lead to the erosion of lending standards and in extreme cases even contribute to market crashes. Mortgage REITs carefully manage these risks to ensure a steady flow of capital, all while maintaining market stability.
3. How Lending Standards Shape CRE
Lending standards act as a gateway to financing, essentially deciding which projects get the green light and which don’t.
Mortgage REITs have their own set of lending standards which they use to evaluate potential borrowers and assess a projects viability. These might include the borrower’s credit score, property value, and projected cash flow expected from the project.
More lenient lending standards can accelerate the pace of property development, allowing for more and often bigger projects take place.
Stricter lending standards often limit expansion in the CRE market but decrease lenders’ risk exposure. It’s common to find mortgage REITs loosening their lending criteria when the greater economic climate is flourishing, to support more development.
Conversely, during times of economic downturn, they will tighten their standards to reduce their risk of loss. In this cyclical manner, lending standards strongly influence the health of the CRE market.
4. Interest Rates and the CRE Market
Much like the way the state of the greater economy influences lending standards, interest rates also have an impact on the overall wellbeing of the CRE market.
Lending interest rates offered by commercial mortgage REITs are typically tied to interest rates set by a country's central bank, such as the Federal Reserve in the United States. In the US, this rate is called the ‘federal funds rate’.
Mortgage lenders usually add an additional percentage, referred to as a margin, to formulate their own lending rates.
During times of economic volatility, the federal funds rate is often increased to control inflation. This in turn, increases lending rates and elevates the cost of borrowing for CRE projects. Faced with reduced profit margins, some projects may be shelved or reduced in scope.
This slowdown in CRE construction often triggers a series of ripple effects, such as decreased demand for construction services and materials, which impact the general CRE market. In such climates, commercial mortgage REITs might tighten their lending standards to reduce potential risk.
It's important for CRE investors to realize that projects can be still profitable even in times of volatile interest rates.
In fact, there are often opportunities to be gained during these times for the financially savvy, which are missed by more cautious investors.
The most important thing is to closely monitor financial metrics and adjust your strategy accordingly, possibly through techniques like hedging or negotiating more flexible loan terms with REITs.
5. The Importance of LTV Ratios for Commercial Mortgage REITs
The loan-to-value (LTV) ratio is an indication of the percentage of a commercial property’s market value that a commercial mortgage REIT is willing to finance. A typical LTV ratio used by these lenders falls between 60% and 80%.
Lower LTV ratios are safer for lenders because the borrower has more ‘skin in the game’, thus reducing the lender's risk.
A higher LTV ratio may result in a loan with a higher interest rate or require more stringent checks on the borrower to secure the financing.
While a high LTV might give the borrower access to more finance, a lower LTV is generally advantageous for better profit margins overall.
It’s a balancing act that CRE investors must negotiate.
General CRE market conditions can also affect LTV ratios. In a time of economic boom, mortgage REITs will be more willing to take on risk and offer higher LTVs. During times of recession or instability, they will become more conservative and risk averse.
6. Location, Location, Diversification
To create balance and stability for investors, commercial mortgage REITs focus on diversification across locations and property types.
This means they might spread their mortgages across a mix of commercial property types like office buildings, retail, industrial, hospitality, multifamily, healthcare, and more.
This diversification strategy allows mortgage REITs to distribute their risk across several CRE markets, making them adaptable to different economic climates.
In terms of geographical diversity, they might also have a mix of high-street locations in prime areas like New York and California, but also choose less obvious locations like affordable housing and industrial complexes in Ohio or Tennessee.
Unlike conventional lenders, commercial mortgage REITs are often more open to funding ‘higher risk’ projects like a niche renewable energy project, or a mixed-use project in an up-and-coming area. The overall stability of their diversified portfolio allows them to take on these ad hoc risks, as they are better able to weather challenges when they arise.
For the CRE developer or broker, wondering which REIT to approach for funding, scrutinizing a particular REIT’s diversification strategy can help borrowers tailor their proposals to meet the REIT’s objectives – potentially making it easier to secure funding. It’s also worth noting that lending interest rates vary depending on location and project type.
7. Ensuring Regulatory Compliance
Since commercial mortgage REITs are responsible for handling investors’ money, they must comply with strict regulations, which includes transparency. For both investors and CRE owners seeking financing, regulations aim to provide a clear window into the REIT's operations and financial status.
In the United States, REITs are governed by regulatory bodies such as the US Securities and Exchange Commission (SEC) and laws such as the Dodd-Frank Act.
Regulations evolve over time and it’s essential that these REITs stay compliant and transparent, as their lending abilities and risk management strategies may be affected. Investors also need to stay abreast of changes so they can ensure their money is secure.
Final Thoughts on the Importance of Commercial Mortgage REITs in CRE
While equity REITs might be the most visible players in the CRE market, commercial mortgage REITs serve an equally important purpose by offering essential financial backing. Without them, many projects would never become a reality.
Whether you’re new to CRE investment and gaining an understanding of the dynamics at play, a broker seeking finance for your client’s visionary development, or a seasoned developer managing large-scale projects, deepening your understanding of mortgage REITs is a long-term investment in your own success. You’ll be able to better navigate CRE investment risks and open the door to new opportunities.
In a landscape as complex and competitive as commercial real estate, knowing the nuances of the market could be the key to getting the green light on your dream project.