kbra reit rating factors

May 19, 2015

Analytical Contacts:

Boris Alishayev, Associate Director

[email protected], (646) 731-2484

Marjan Riggi, Managing Director


Christopher Whalen, Senior Managing Director


Jay Zhou, Associate


U.S. Financial Institutions

Mortgage REIT & REFC Rating Methodology

Mortgage REIT & Real

Estate Finance Company

Rating Methodology

Mortgage REIT & REFC Rating Methodology Page | 2 May 19, 2015

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

Table of Contents


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


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:

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

Derive at least 75% of gross income from qualified investments (real property or debtsecured by real property)

Derive at least 95% of gross income from qualified investments, including dividendsand interest from non-real estate sources, or gains from security sales

Distribute at least 90% of taxable income annually as dividends

Income Requirements

Maintain at least 75% of total assets in equity ownership of real property or loanssecured 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 valuecomprises more than 5% of the REITs assets

Investment 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

Ownership Requirements


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 long-

term 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.


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:

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.

Determinant Summary

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

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

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

Business Factors (25%)

Financial Factors (50%)

Real Estate Factors (25%)

Key Rating Determinants


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.

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.

AVery long operating history; large by assets or market

cap; significant market share

BBBLong operating history; medium by assets or market

cap; considerable market share

BBAverage operating history; small by assets or market

cap; modest market share

B or BelowLimited operating history; very small by assets or

market cap; small market share

Track Record and Market Position


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.

A

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.

Corporate Governance


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.

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

1 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.

ARobust and comprehensive risk management framework

addressing all areas of risk

BBBComprehensive risk management framework addressing

all areas of risk

BBDeveloping risk management framework but addressing

all areas of risk

B or BelowExposure to risk in framework, failing to address all

areas of risk

Risk Management


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.

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

Sub-Determinants A BBB BB B or Below

Access to Capital

Highly reliable and

diverse financing

sources

Sufficiently reliable

and diverse financing

sources

Moderately reliable

and diverse financing

sources

Limited contingent

financing sources

available

Liquidity Coverage

Strong internal

liquidity; dependable

and committed

available bank

facilities; internal

funding covers 2

year's cash

requirements

Ample internal

liquidity; committed

bank facilities with

some covenant

compliance room;

some reliance on

external funding to

cover 2 year's cash

requirements

Adequate internal

liquidity; committed

bank facilities with

little covenant

compliance room;

some reliance on

external funding to

cover 2 year's cash

requirements

Insufficient internal

liquidity and

committed bank

facilities; reliance on

uncertain external

funding to cover 2

year's cash

requirements

Unencumbered Assets

Sizable amount of

financial assets not

pledged as collateral

for secured financing

Sufficient amount of




Moderate amount of




Limited amount of




Funding and Liquidity


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.

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.

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


Debt-to-Equity Ratio 8x

Tangible Common Equity Ratio >15% 15%-10% 10%-5%


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.


Net Interest Margin >4% 4%-3% 3%-2% 3x 3x-2x 2x-1.5x


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.

A

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.

Residential Portfolio Composition


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.

A

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 non-

income 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.

Commercial Portfolio Composition


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.

AMinimal level of delinquencies, loan loss provisions and/or charge-

offs relative to portfolio

BBBLow level of delinquencies, loan loss provisions and/or charge-offs

relative to portfolio

BBModerate level of delinquencies, loan loss provisions and/or charge-

offs relative to portfolio

B or BelowHigh level of delinquencies, loan loss provisions and/or charge-offs

relative to portfolio

Asset Quality


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