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U.S.

Financial Institutions
Mortgage REIT & REFC Rating Methodology

Mortgage REIT & Real


Estate Finance Company
Rating Methodology

Analytical Contacts:
Boris Alishayev, Associate Director
balishayev@kbra.com, (646) 731-2484

Christopher Whalen, Senior Managing Director


cwhalen@kbra.com, (646) 731-2366

Marjan Riggi, Managing Director


mriggi@kbra.com, (646) 731-2354

Jay Zhou, Associate


jzhou@kbra.com, (646) 731-2441

May 19, 2015

Table of Contents
Executive Summary ............................................................................................................................................................ 3
Overview................................................................................................................................................................................ 3
Characteristics of REITs ............................................................................................................... 3
Types of REITs ............................................................................................................................ 4
Mortgage REIT Market ................................................................................................................. 5
The Rating Approach .......................................................................................................................................................... 6
Business Factor Rating Determinants ............................................................................................................................. 7
Track Record and Market Position .................................................................................................. 7
Corporate Governance ................................................................................................................. 7
Risk Management ........................................................................................................................ 8
Financial Factor Rating Determinants ............................................................................................................................. 9
Funding and Liquidity .................................................................................................................. 9
Leverage .................................................................................................................................. 10
Profitability and Cash Flow ......................................................................................................... 11
Real Estate Factor Rating Determinants ...................................................................................................................... 12
Portfolio Composition ................................................................................................................. 12
Asset Quality ............................................................................................................................ 14
Characteristics of Investment Grade / Higher Quality Mortgage REITs ................................................. 15
Surveillance and Rating Sensitivity ............................................................................................................................... 15

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Executive Summary
This document describes Kroll Bond Rating Agencys (KBRA) rating methodology for U.S. Mortgage Real
Estate Investment Trusts (REITs) and Real Estate Finance Companies (REFCs). The methodology will cover
all residential and commercial mortgage REITs as well as real estate finance companies that may not qualify
for or elect REIT status, but whose asset compositions, capital and funding structures, and business
strategies are similar to those of mortgage REITs.
KBRAs general approach for analyzing mortgage REITs and REFCs includes a comprehensive evaluation of
key qualitative and quantitative determinants, which include an examination of business, financial, and real
estate determinants:

In the first determinant: KBRA examines the companys market position, corporate governance and
risk management;
In the second determinant: KBRA assesses funding & liquidity, leverage and profitability and cash
flow;
In the third determinant: KBRA analyzes portfolio composition and asset quality.

Each of these determinants are scored, and form the primary determinants of our rating. In reports for
specific issuers, KBRA will elaborate on how it analyzed industry- and company-specific determinants and,
in certain circumstances, structural features. KBRA assigns ratings to mortgage REITs and REFCs using its
short-term and long-term rating scales depending on the securities being rated. For more information about
KBRAs rating scale, please see KBRAs Rating Scales and Definitions.

Overview
REITs are investment pass-through vehicles that can be exempt from corporate taxation and are designed
to facilitate the flow of rental income and/or mortgage interest to investors. REITs were created in the 1960s
to allow smaller investors to pool their capital and invest in large-scale, income-producing real estate. Since
then, REITs have evolved and benefited from a number of tax law and legislative changes. Today, REITs are
actively managed total return funds that raise capital in public and private equity and debt markets and
invest in a broad range of real estate assets.
Similar to REITs, REFCs are companies that invest in real estate debt; however, they do not meet the
necessary structural and regulatory requirements to qualify as a REIT and are not exempt from corporate
taxation. Furthermore, REFCs generally retain and reinvest earnings instead of distributing them to
shareholders and have greater flexibility in real estate investments than do REITs.

Characteristics of REITs
REITs differ from other corporations in that their tax status under the U.S. Internal Revenue Service (IRS)
tax code allows them to reduce or eliminate taxation at the corporate level. Instead, income from REITs is
taxed mainly at the shareholder level, thus avoiding double taxation for investors. REITs are potentially
subject to tax on: 1) undistributed taxable income, 2) undistributed net capital gains, 3) income shortfalls
resulting from the failure to meet certain income requirements, 4) income from foreclosed properties, 5)
income from prohibited transactions, and 6) income from re-determined rents.
REITs can be either public or private companies, and can be internally or externally managed. Over 90% of
public REITs are internally managed, meaning they operate like any other company with a board,
management, and employees. Smaller REITs or non-traded REITs are often externally managed because of

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limited resources and so can benefit from the expertise and scale of a more established manager with a
broader range of services and business relationships.
To qualify as a REIT, a company must comply with the following income, investment, and ownership
requirements:

Income
Requirements

Derive at least 75% of gross income from qualified investments (real property or debt
secured by real property)
Derive at least 95% of gross income from qualified investments, including dividends
and interest from non-real estate sources, or gains from security sales
Distribute at least 90% of taxable income annually as dividends

Investment
Requirements

Maintain at least 75% of total assets in equity ownership of real property or loans
secured by real property
Have no more than 25% of assets invested in taxable REIT subsidiaries
Own no more than 10% of the voting securities of any corporation other than another
REIT, taxable REIT subsidiary (TRS), or qualified REIT subsidiary (QRS)
Cannot own stock of a corporation other than another REIT, TRS, or QRS whose value
comprises more than 5% of the REITs assets

Ownership
Requirements

Have a minimum of 100 shareholders


Have no more than 50% of shares outstanding owned by five or fewer individuals
(5/50 Rule)
Be managed by a board of directors or trustees

Types of REITs
There are three general types of REITs based on the type of interest they own in real estate: equity REITs,
mortgage REITS, and hybrid REITs. Equity REITs own real property (land and buildings), mortgage REITs
invest in residential and commercial mortgages, as well as residential mortgage-backed securities (RMBS)
and commercial mortgage-backed securities (CMBS), and hybrid REITs own both real estate and real estate
debt. Currently, equity REITs dominate the U.S. REIT industry and represent 90% of its market
capitalization. The remainder is comprised of mortgage REITs (9%) and hybrid REITs (1%).
Equity REITs acquire commercial and residential properties and derive income from operating the properties.
They are typically segmented by property type, comprising residential, retail, office, health care,
industrial/warehouse, lodging/resorts, self-storage, timber, and infrastructure. Mortgage REITs, on the
other hand, provide financing for real estate by originating or purchasing mortgages and/or MBS and
generate income from the interest on the loans and sales of mortgages. Generally, mortgage REITs
specialize in either residential or commercial assets. Residential mortgage REITs focus mainly on acquiring
single-family (1-4) home loans and RMBS and can be further classified as agency or non-agency based on
the majority holdings of the portfolio, although most that hold non-agency/private-label RMBS also own
agency-backed securities. Commercial mortgage REITs invest primarily in loans and securities backed by
commercial and multifamily properties. Hybrid REITs incorporate some combination of these business
strategies.
There are also a few specialized REITs such as net lease REITs that focus on ownership of equity and/or
debt on single-tenant properties and REITs that focus on non-performing loans, either directly or via the

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purchase of a Real Estate Mortgage Investment Conduits (REMIC). New entrants such as single-family rental
(SFR) REITs, which may be equity, debt, or hybrid in nature, are also gaining popularity.

Mortgage REIT Market


Currently, there are 21 listed residential mortgage REITs with a market capitalization of $41.0 billion, 14
listed commercial mortgage REITs with a market capitalization of $19.1 billion, and 3 diversified mortgage
REITs that invest in a combination of residential and commercial assets with a market capitalization of $4.0
billion. These real estate companies have opened up the mortgage market to a different class of investors
by offering investments in mortgage loans and MBS with the liquidity and transparency of publicly traded
equities.
Mortgage REITs have grown significantly since the financial crisis, more than tripling in size from the
valuation troughs of 2008 and 2009. The mortgage REIT market currently exceeds $60 billion in market
cap, up from $14 billion at the end of 2008, according to National Association of Real Estate Investment
Trusts (NAREIT). Most of the growth is attributed to acquisitions of agency- and GSE-backed securities,
supported by government programs encouraging private investment and the relative undervaluation of
these securitized products at the time of their purchase.
Despite their concentrated portfolio in agency MBS, mortgage REITs currently hold less than 5% of the $6
trillion agency MBS market. The Federal Reserve, banks, foreign investors, mutual funds, and other
institutional investors all had larger holdings of agency MBS. This diverse and very liquid market provides
mortgage REITs with further opportunities to expand and recapitalize the market.
Most residential mortgage REITs have substantial investments in agency RMBS. Given the explicit and
implicit guarantees by the U.S. government for such securities, credit risk exposure to the individual
borrower is very limited. However, these securities are still exposed to interest rate risk and market risk,
which can affect the net interest margin and the value of the securities. Therefore, it is important to take a
closer look at these companies and their risk management practices during periods of interest rate volatility.
During the past decade, the market has experienced a number of periods with wide fluctuations in interest
rates as summarized below:
Spring 2003: Volatile short- and long-term interest rates due to sluggish economic performance, rising
energy prices, and sharply lower interest rates, in some cases to historic lows;
2004-2006: Rising short-term interest rates due to the Feds increase in the target federal funds rate and
a related rise in yields on the long end of the curve;
2008-2009: Volatile rates due to the global financial crisis and the retreat of investors from the financial
markets drove MBS prices down and forced yields into mid-single digits;
2nd Half of 2013: Rising long-term interest rates due to the Feds tapering announcement; short- and longterm interest rates surged due to press conference by Fed Chairman Ben Bernanke; prepayment rates and
TBAs (to-be-announced) did not perform as expected by many market participants.
Despite some volatility and uncertainty about rate movements throughout these periods, the long-term
financial performance of agency mortgage REITs was not impaired. Utilizing hedging strategies and active
asset and liability management, these companies were able to maintain their funding and liquidity positions.

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The Rating Approach


KBRAs analytical approach to mortgage REITs and REFCs includes an assessment of business, financial,
and real estate determinants, all of which determine the final credit rating of an issuer and/or obligation.
Business factor rating determinants capture the non-financial aspects of mortgage companies and are based
on KBRAs view of a firm and the operating environment. Financial factor rating determinants concentrate
on the entitys financial profile and revolve around a largely ratio-based analysis. Real estate factor rating
determinants focus on the quality of a companys real estate investments and incorporate qualitative and
quantitative measures of risk. These rating determinants are summarized in the following table:

Key Rating Determinants


Determinant

Summary

Business Factors (25%)


Track Record and Market Position (5%)

Considers a company's overall track record and market


position

Corporate Governance (5%)

Evaluates the overall quality of management and the


board of directors, determining the level of oversight and
quality of corporate governance standards

Risk Management (15%)

Determines a company's ability to manage against


market, credit, counterparty, liquidity, operational,
compliance, regulatory, and legal risk

Financial Factors (50%)


Funding and Liquidity (20%)

Assesses a company's ability to access financing and


meet its liquidity needs

Leverage (20%)

Measures the strength of the capital structure and


leverage utilization relative to a REIT's portfolio

Profitability and Cash Flow (10%)

Examines the quality and consistency of earnings and


cash flows

Real Estate Factors (25%)


Portfolio Composition (15%)

Evaluates a company's portfolio by the inherent credit


risk and market risk of each type of investment

Asset Quality (10%)

Weighs the level of delinquencies and charge-offs of the


portfolio against asset type

In the evaluation of business factors, the analysis is centered on qualitative factors and discussions with
management. KBRA places greater weight on risk management as the future viability of a company is a
direct result of how well the risks of the business are managed over time. The assessment of financial factors
typically entails the analysis of at least three years of audited financial results, although it may include fewer
years under special circumstances. In addition, KBRA may apply stress testing to the current portfolio and
capital structure in order to provide a more forward looking view of the financial profile.
KBRA assigns scores to each rating determinant using a rating scale from A to B or below, broadly indicating
the range of credit ratings that may be issued. KBRA believes that most mortgage companies fall within this
credit range and are constrained from achieving higher ratings mainly due to their considerable dependence
on wholesale funding and limited ability to retain cash flow.

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Given the differences between REITs and REFCs, KBRA will approach each rating on a case-by-case basis,
taking into account all rating factors as well as other considerations which may not be mentioned in this
methodology but may be important for a specific firm. In particular, where one or more rating factors are
noticeably weak, KBRA may adjust the weights to reflect the firms vulnerability to those factors. Conversely,
the aggregate rating may be adjusted upward if positive external factors are present, such as a change in
the regulatory environment or strong economic fundamentals for a particular real estate asset. Other
factors, such as KBRAs outlook for the industry and any potential impact on a companys business plan,
may also shift the weights and affect the ultimate rating assignment.

Business Factor Rating Determinants


Mortgage REITs and REFCs operate in a challenging business environment, dictated by the financial markets,
financial regulation, and the actions of the Federal Reserve. The strategic objectives of a firm are oftentimes
susceptible to the movements of its competitors and the multitude of risks present in the industry. Therefore,
a companys market position, corporate governance, and risk management are key factors in determining
the rating.

Track Record and Market Position


The real estate debt market is highly competitive and is becoming more saturated with new entrants,
resulting in higher prices and lower yields on target assets. Mortgage REITs and REFCs face stiff competition
from financial institutions such as banks, savings and loan institutions, and life insurance companies,
institutional investors, including mutual funds, pension funds, hedge funds, and government entities. When
evaluating the competitive landscape, KBRA gives consideration to the firms size, market share, ownership
and operating history, among other factors.
Track Record and Market Position

Very long operating history; large by assets or market


cap; significant market share

BBB

Long operating history; medium by assets or market


cap; considerable market share

BB

Average operating history; small by assets or market


cap; modest market share

B or Below

Limited operating history; very small by assets or


market cap; small market share

Corporate Governance
Corporate governance standards along with the organizational structure are examined in detail to ensure
that a company has the level of oversight needed to properly operate and manage its business in the interest
of its shareholders. Emphasis is placed on the quality of management and the board of directors, typically
by reviewing management experience and corporate governance guidelines. Relationships and
responsibilities among different participants in the corporation, such as the board of directors, managers,
shareholders, creditors, auditors, and regulators, are also examined. For companies without an internal
manager, the external manager and other related parties are evaluated as part of the rating process.

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Corporate Governance

Management team considered highly experienced, with prior history of


managing successfully through the economic/interest rate cycles. Highly
accountable and independent board of directors to oversee all aspects of
corporate governance. Robust corporate governance standards.

BBB

Management team considered seasoned, with prior history of managing well


through the economic/interest rate cycles. Accountable and independent
board of directors to oversee all aspects of corporate governance. Strong
corporate governance standards.

BB

Management team considered adequate, with prior history of some


vulnerability in management through the economic/interest rate cycles.
Fairly accountable and independent board of directors to oversee corporate
governance. Adequate corporate governance standards.

B or Below

Management team considered moderately weak, with prior history of


managing poorly through the economic/interest rate cycles. Weaknesses
exist in the accountability and independence of the board of directors in the
oversight of corporate governance. Inadequate corporate governance
standards.

Risk Management
Mortgage REITs and REFCs conduct business under a great number of risks surrounding the economy,
financial markets, and regulatory environment. Primary risks include market risk, credit/counterparty risk,
liquidity risk, operational risk, and compliance/regulatory/legal risk. The effective management of these
risks is critical to the overall success of a firm, and KBRA views risk management as one of the more
important rating determinant for mortgage REITs and REFCs.
Of particular importance is the management of market risks relating to interest rates, prepayment speeds,
and reinvestment opportunities, which greatly impact earnings, capital, and the overall business. Changes
in interest rates could affect the value of a companys mortgage assets and their cost of financing
significantly. Prepayment risk is largely a function of interest rates and may lead to reinvestment risk in a
declining rate environment. To manage these risks, mortgage REITs and REFCs employ a number of hedging
strategies. In KBRAs view, the effectiveness of these strategies, in addition to the accompanying
counterparty risk management, is central to the quality of market risk and credit risk management. Other
types of credit risk include the credit exposure of extending or investing in a given loan or MBS, which may
vary in risk. Market risk and credit risk are examined in more detail in the Portfolio Composition section
under Real Estate Factor Rating Determinants.
Liquidity risk, stemming from a potential funding mismatch and/or duration gap between assets and
liabilities, is another important consideration. These risks can be exacerbated due to uncertainty as to the
rate of prepayments in mortgages. To manage liquidity risk, firms are expected to maintain policy tools
addressing funding, excess liquidity, and the maturity profile of their assets and liabilities. In KBRAs
evaluation of risk management practices, we look for active asset and liability management, which may
include the staggering, extension, or matching of liability maturities with asset maturities, balance sheet
stress testing, counterparty management, and specialized asset selection.

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Operational risk can result from the inadequacy or failure of internal processes or systems, and may lead to
financial loss and reputational damage. KBRA reviews all aspects of operational risk management, including
the robustness of internal systems and controls, standard policies and procedures, and independent
committees to monitor and assess risk.
As the financial services industry involves extensive regulation and oversight, the ability of an issuer to
manage compliance, regulatory, and legal risk is an ongoing concern. Changes in the regulatory environment
may impact the business conduct, especially for REITs, as these companies must comply with more stringent
requirements to maintain their REIT status. As part of the risk management analysis, KBRA closely follows
any developments that may arise from the legal and regulatory realms.
Risk Management

Robust and comprehensive risk management framework


addressing all areas of risk

BBB

Comprehensive risk management framework addressing


all areas of risk

BB

Developing risk management framework but addressing


all areas of risk

B or Below

Exposure to risk in framework, failing to address all


areas of risk

Financial Factor Rating Determinants


For mortgage REITs and REFCs, investing in real-estate-backed debt inherently involves taking significant
risk as it requires the use of leverage through short-term funding; therefore, the success of these companies
is directly correlated with their ability to obtain and leverage capital in addition to preserving a strong
liquidity position. As such, funding and liquidity, profitability and cash flow, and leverage are all
interconnected, and any weakness in any of the above factors may pose a rating constraint.

Funding and Liquidity


Given restrictions on income retention and the capital-intensive nature of mortgage REITs and REFCs,
funding and liquidity form the cornerstone of credit strength. The ability to access reliable and diverse
financing and fulfill liquidity needs is tantamount to a strong credit profile. In determining the quality of
funding and liquidity, KBRA examines access to equity and debt capital, liquidity coverage, and
unencumbered assets among many other factors for mortgage companies.
Access to Capital
Mortgage REITs and REFCs rely mainly on the equity capital markets to secure long-term capital. Primary
sources of short-term funding may include repurchase agreements, dollar roll transactions,1 warehouse
facilities, and bank credit facilities. Other sources of funding consist of loans, unsecured bonds,
securitizations, participations sold, convertible bonds, and preferred stock. Because short-term financing is
critical to their business strategy, access to these particular sources of capital is crucial for long-term
Mortgage dollar roll is similar to a reverse repurchase agreement and provides a form of collateralized short-term financing with MBS
comprising the collateral. The company sells MBS for settlement on one date and buys it back for settlement at a later date.
1

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sustainability. KBRA also takes into account the diversification of counterparties to minimize over-reliance
on any specific lender. By maintaining relationships with many creditors, these firms can reduce liquidity
shortfall risk.
Liquidity Coverage
Mortgage REITs and REFCs derive their sources of liquidity from operating cash flows, bank lines, asset
sales, and access to the capital markets. Uses of liquidity include debt repayments, dividend payments, and
capital expenditures. KBRA examines liquidity coverage by comparing available cash or cash equivalents,
committed and undrawn credit facilities, and projected operating cash flows after dividend payments, to
projected recurring capital expenditures and debt obligations over the next 24 months.
Unencumbered Assets
The availability of unencumbered assets is an important alternative source of liquidity for mortgage REITs
and REFCs and offers financial flexibility and protection from funding concerns, serving as collateral for
secured financing or held as available for sale. An asset that has not yet been pledged as collateral against
an existing liability is considered unencumbered. KBRA calculates the ratio of unencumbered financial assets
to total financial assets to gauge contingent liquidity levels, which is especially important during periods of
market stress.
Funding and Liquidity
Sub-Determinants

Access to Capital

Highly reliable and


diverse financing
sources

Liquidity Coverage

Unencumbered Assets

BBB

Sufficiently reliable
Moderately reliable
and diverse financing and diverse financing
sources
sources

Ample internal
Strong internal
liquidity; committed
liquidity; dependable
bank facilities with
and committed
some covenant
available bank
compliance room;
facilities; internal
some reliance on
funding covers 2
external funding to
year's cash
cover 2 year's cash
requirements
requirements
Sizable amount of
financial assets not
pledged as collateral
for secured financing

BB

Sufficient amount of
financial assets not
pledged as collateral
for secured financing

B or Below
Limited contingent
financing sources
available

Adequate internal
Insufficient internal
liquidity; committed
liquidity and
bank facilities with
committed bank
little covenant
facilities; reliance on
compliance room;
uncertain external
some reliance on
funding to cover 2
external funding to
year's cash
cover 2 year's cash
requirements
requirements
Moderate amount of
Limited amount of
financial assets not financial assets not
pledged as collateral pledged as collateral
for secured financing for secured financing

Leverage
Fundamentally, mortgage REITs and REFCs rely on leverage, using borrowed money to significantly enhance
total return. Therefore, appropriate risk-based leverage and capitalization, as well as managements
tolerance levels for leverage, are important factors to consider when analyzing these companies. Key
leverage metrics for mortgage companies consist of the debt-to-equity ratio and the tangible common equity
ratio.
Debt-to-Equity Ratio
The ratio of total interest-bearing liabilities to total equity is a standard measure of leverage, which is usually
greater for mortgage REITs and REFCs than for other finance and investment companies. The higher the
leverage, the lower the capacity for borrowing, which typically results in higher interest costs. A company

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should employ leverage commensurate with the type of securities held for a balanced risk-return profile and
to mitigate financial risk. In the treatment of preferred stock, KBRA may assign credit to both debt and
equity depending on the characteristics of the security.
Tangible Common Equity Ratio
Tangible common equity (TCE) to tangible assets is a measure of capital adequacy and financial strength.
Moreover, it determines capacity for additional leverage. Higher levels of equity capital against assets
protect a firm from compromising its ability to pay off obligations and help cushion a firm from unexpected
financial shocks. For this calculation, TCE consists of total equity less preferred stock, goodwill, deferred tax
assets, and other intangible assets that do not produce income and do not have a cash equivalent value.
Tangible assets2 are defined as total assets less goodwill, deferred tax assets, and other intangible assets.
KBRA notes that credit for deferred tax assets may be given to REFCs that have demonstrated certainty in
realizing these tax benefits as measured by their valuation allowance.
Leverage
Sub-Determinants

BBB

BB

B or Below

Debt-to-Equity Ratio

<4x

4x-6x

6x-8x

>8x

Tangible Common Equity Ratio

>15%

15%-10%

10%-5%

<5%

Profitability and Cash Flow


The quality and consistency of a mortgage companys cash flows and earnings are a function of numerous
market and business factors. Profitability is especially dependent on the ability to manage the business
through changing economic and interest rate environments given the sensitivity of mortgage REITs and
REFCs to interest rate movements. As for profitability measures, KBRA reviews the net interest margin and
fixed charge coverage, among other metrics.
Net Interest Margin
Net interest income, the primary source of earnings for mortgage companies, is generated from interest
income on assets with longer-dated maturities and interest expense on shorter-term liabilities. The net
interest margin (NIM) expresses the net interest income as a percentage of average interest-earning assets
for the period. NIM is highly susceptible to interest rate risk if not match-funded, and management must
prudently manage the impact of changes in short- and long-term interest rates on the effective duration of
a portfolio.
Fixed Charge Coverage
This ratio measures a companys ability to cover its fixed expenses with income before depreciation,
amortization, interest expense and taxes and is calculated as the sum of pre-tax income from continuing
operations and fixed charges divided by fixed charges. Fixed charges include all interest expensed and
capitalized, preferred dividends, and other significant recurring fixed costs such as amortized premiums,
discounts, and capitalized expenses related to indebtedness. A higher fixed charge coverage indicates a
stronger earnings profile relative to interest expense and is a credit positive for bondholders.

KBRA includes mortgage servicing rights (MSRs) as part of tangible assets as MSRs have real market value and can be sold.

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Profitability and Cash Flow


Sub-Determinants

BBB

BB

B or Below

Net Interest Margin

>4%

4%-3%

3%-2%

<2%

Fixed Charge Coverage

>3x

3x-2x

2x-1.5x

<1.5x

Real Estate Factor Rating Determinants


Real estate and real estate debt are income-producing investments that vary in risk depending on the nature
of the assets. As such, the quality of a firms portfolio within the broader real estate markets it operates in
is a key factor in determining the rating. In KBRAs assessment of mortgage REITs and REFCs, scrutiny is
given to portfolio holdings in addition to asset quality metrics, such as delinquency and charge-off rates.

Portfolio Composition
KBRA evaluates the portfolio by the inherent credit risk and market risk of each type of investment, giving
consideration to property-specific, loan-specific, and bond-specific risks. Due to differences in market
dynamics, residential and commercial mortgage portfolios are examined in conjunction with KBRAs
CMBS/RMBS group.
Residential
Investments in a residential portfolio may consist of individual residential mortgages and RMBS, which are
often categorized as agency or non-agency. However, there may be some exposure to second homes and
investment properties as well, including smaller multifamily properties (2 to 4 units). Many residential
mortgage portfolios invest in agency RMBS, which are considered free of credit risk as they are either
explicitly guaranteed by the U.S. government in the case of Ginnie Mae, or have an implicit guarantee by
the U.S. government in the case of Fannie Mae and Freddie Mac. In both cases, investors rely on the
creditworthiness of the U.S. government instead of the individual borrower. That being said, agency-backed
securities carry considerable market and prepayment risk, which can have credit implications for the
portfolio of such securities and for those who manage and hold them.
Furthermore, mortgage REITs invest in non-agency MBS and mortgage servicing rights (MSRs), which
provide REITs with two benefits. First, investing in non-agency MBS improves the net interest spread for
the company as these securities offer higher yields due to the added credit risk on investments. And second,
investing in MSRs hedges the companys portfolio in a rising interest rate environment. MSRs increase in
value as interest rates increase. On the downside, investing in non-agency securities exposes the companies
to additional credit risk, market/interest rate risk, prepayment risk and transactional risk.
Macroeconomic factors such as interest rates, home prices, and unemployment rates constitute market risk
and considerably affect asset values. The risk of prepayment is sensitive for residential portfolios and is
influenced by both interest rates and home prices, determining the frequency of borrowers to either
refinance or sell their homes. Changes in the constant prepayment rate (CPR) may reduce the yield on the
residential investments in the companys portfolio.

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Residential Portfolio Composition

Portfolio comprised primarily of low to moderate leverage first-lien mortgages


(very limited exposure to junior liens) on owner-occupied properties and/or
highly rated securities. Minimal value derived from first loss non-rated positions
in securitizations. Highly diversified across geography, property type and
sponsor. Limited exposure (direct or indirect) to low-quality counterparties.

BBB

Portfolio comprised of moderate leverage first-lien mortgages (some exposure to


junior liens) and/or a mix of senior and mezzanine securities. Limited value
derived from first loss non-rated positions in securitizations. Well diversified
across geography, property type and sponsor.

BB

Portfolio comprised of moderate to high leverage senior and junior liens and/or a
mix of senior, mezzanine, and subordinate securities. Moderate exposure to
riskier investments such as below investment-grade securities or first-loss
securities. Exhibits material concentration of geography or collateral type.

B or Below

Portfolio comprised of very high leverage senior loans, has very significant
exposure to junior liens and below investment-grade and equity securities. High
exposure to volatile asset types. Significant concentration of geography or
collateral type.

Commercial
Commercial real estate (CRE) investments may include loans and/or securities. CRE loans can include senior
debt such as first mortgages and A-Notes, or subordinate debt such as B-Notes, mezzanine debt, and
preferred equity with debt-like characteristics. CRE securities primarily encompass rated or unrated tranches
from conduit/fusion CMBS, agency multifamily CMBS (agency guaranteed or unguaranteed tranches), single
asset single borrower securitizations, large loan floaters, CRE collateralized loan/debt obligations (CRE CLOs
and CRE CDOs), small balance commercial securitizations, and re-REMICs. The tranches held as an
investment may range from highly rated securities (AAA/AA), mezzanine certificates (A/BBB), below
investment-grade debt (BB/B), and equity positions which are the most subordinate, unrated tranches in
a given transaction. The CRE investments may pay interest at either fixed or floating rates, have expected
maturities ranging from two to ten years, and have interest-only or amortizing structures.
The properties securing the loan investments and the loan collateral underlying securitizations are typically
income-producing assets, which may be stabilized or non-stabilized. The underlying property types can
include office, retail (malls, centers, freestanding, restaurants), industrial and warehouse properties, lodging
assets, multifamily apartment complexes, manufactured home communities, and self-storage facilities,
among others.
Commercial real estate is a non-homogeneous asset class, and credit risk from investments in this asset
class is idiosyncratic. This may include property-specific risks relating to an assets quality, location,
occupancy, and scheduled lease rollover; sponsor risk; loan-specific risks relating to term, leverage, and
structure.

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Commercial Portfolio Composition

Portfolio comprised primarily of low to moderate leverage first mortgage loans


(very limited exposure to subordinate loans) and/or highly rated securities. Minimal
value (or very low leverage) derived from investments collateralized by transitional
or non-income producing commercial assets, such as construction loans and land,
or first loss non-rated positions in securitizations. Highly diversified across
geography, property type, sponsor, and tenants. Limited exposure (direct or
indirect) to low-quality counterparties (such as non-investment grade tenants,
weak hedging counterparties). Limited exposure to higher volatility property types.

BBB

Portfolio comprised of moderate leverage first mortgage loans (some exposure to


subordinate loans) and/or a mix of senior and mezzanine securities. Limited value
(or low leverage) derived from investments collateralized by transitional or nonincome producing commercial assets, such as construction loans and land, or first
loss non-rated positions in securitizations. Well diversified across geography,
property type, sponsor, and tenants.

BB

Portfolio comprised of moderate to high leverage senior and subordinate loans


and/or a mix of senior, mezzanine, and subordinate securities. Moderate exposure
to riskier investments such as below investment-grade bonds, first-loss securities,
construction loans, land loans, and volatile property types. Exhibits material
concentration of geography, low-quality tenancy, and collateral type.

B or Below

Portfolio comprised of very high leverage senior loans, has very significant
exposure to subordinate loans and below investment-grade and equity securities.
High exposure to volatile asset types such as construction loans, land loans, and
volatile property types. Significant concentration of geography, low-quality
tenancy, and collateral type.

Asset Quality
Residential mortgage REITs invest in agency and non-agency securities. Agency securities are issued by
government sponsored entities (GSEs) such as Ginnie Mae, Fannie Mae, Freddie Mac or the Federal Home
Loan Banks and are backed by the full faith and credit of the U.S. government. Non-agency securities are
issued by non-governmental financial institutions that are not eligible for purchase by the GSEs and contain
credit risk. KBRA will evaluate asset quality and degree of credit risk in the non-agency portfolios by
analyzing the mix and quality of properties, tenants, geographic diversification, loan tenor and stability of
cash flow.
Delinquent and Non-Performing Loans
The level of delinquent non-performing loans is a crucial aspect of evaluating asset quality of the portfolio.
KBRA focuses on delinquent and non-performing loans as a percentage of total loans and total assets. The
non-performing loan portfolio is an indication of the asset quality and ultimately that of the companys risk
management. The analysis of delinquent and non-performing loans will cover a number of aspects, including
aging of past-due loans, reasons for deterioration, provision levels and impact to earnings.
Loss Provisions and Charge-offs
KBRA will review the level of loan loss provisions put in place to record potential losses. When assessed, the
aggregate level of loan loss provisions and ultimate net charge-offs indicates the capacity of a REIT to
effectively accommodate credit risk.

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Asset Quality
A
BBB
BB
B or Below

Minimal level of delinquencies, loan loss provisions and/or chargeoffs relative to portfolio
Low level of delinquencies, loan loss provisions and/or charge-offs
relative to portfolio
Moderate level of delinquencies, loan loss provisions and/or chargeoffs relative to portfolio
High level of delinquencies, loan loss provisions and/or charge-offs
relative to portfolio

Characteristics of Investment Grade / Higher Quality Mortgage


REITs
In applying the methodology, Mortgage REITs that will be able to achieve investment grade rating will have
the following characteristics.

Strong management team with deep industry knowledge


Established operating track record that has been tested through market cycle
Strong corporate governance, regulatory compliance and other reporting requirements
Robust risk management platform
Consistent access to multiple sources of capital
Strong liquidity profile with sources exceeding uses of liquidity
Leverage levels, measured as debt to equity and net debt to EBITDA, are 5.0x and 6.0x, respectively
Interest coverage, measured as EBITDA to interest incurred is 2.0x or better

Generally Mortgage REIT wont achieve ratings in the highest investment grade categories due to inherently
limited cash retention capacity, which limits growth and debt service.

Surveillance and Rating Sensitivity


KBRA monitors outstanding ratings based on periodic information provided by the companies and conducts
formal reviews of its ratings annually. In addition, analysts generally monitor market information, publicly
released financials, and other disclosures in order to maintain current rating opinions. KBRA will typically
include in ongoing reviews an analysis of the rating determinants as outlined above.

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fitness for any particular purpose of any rating or other opinion or information is given or made by KBRA. Under no circumstances shall
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