By Jada A. Graves

As some equity REITs blaze trails internationally, mortgage REITs have remained largely on the sidelines. However, that may be slowly changing. Some real estate finance companies have discovered creative ways to tap into markets abroad, and while nothing globally yet comes close to the diversity of opportunities available in the U.S. mortgage market, there may be worthwhile investments for companies willing to wade through the maze of tax codes, contract law and other legal restrictions.

"The U.S. mortgage market is unique compared to any other on the globe," says Mike Farrell, chairman, president and chief executive officer of Annaly Mortgage Management, Inc. (NYSE: NLY). To Farrell, the U.S. market stands out for its right to foreclosure and ownership. "Nothing looks, tastes or smells like the U.S. mortgage market."

Perhaps owing to the U.S. market’s experience, REITs have devised ways of investing abroad that have not been similarly seized by foreign investment companies.

Assessing the Situation

What are some of the problems that exist for companies looking to invest abroad? They depend on where your company is headquartered as well as in which country (or countries) you are trying to invest. While REIT-like structures continue to be introduced across the globe, these new platforms develop initially around equity REITs with the creation of mortgage REITs unlikely for several years.

Farrell is among those suggesting that asset securitization markets need to be developed first. Asset securitization, in turn, requires uniform loan insurance, foreclosure and underwriting standards.

Jonathan Dever, senior vice president in the financial institutions group at Lehman Brothers, agrees with Farrell’s hypothesis about the relationship between asset securitization and mortgage REITs. "In Europe the local banks typically hold mortgage loans on their balance sheets and don’t utilize securitization in off balance sheet structures as a means to finance those assets," Dever says.

"I don’t think you’ll see mortgage REITs, per se, appear any time soon. In Europe, I think we’ll see equity REITs take footing first following the passage of new REIT legislation in the U.K. or on the continent. Hopefully, REIT legislation will be passed and embraced and securitization of mortgage-related assets will increase. During the interim, savvy operators have utilized the Guernsey trust as an alternative to the REIT structure."

In the meantime, some U.S. companies are finding ways around potential problems through partnerships with foreign companies, expanding operations abroad or using offshore trusts.

Getting Inventive and Taking Initiative

Farrell says Annaly has been able to create more liquid and sizeable investment opportunities by utilizing specialized investment vehicles available in the country where the transaction would take place. For Annaly, most of their foreign business has occurred in Canada and London, where the company typically bundles a package of assets through closed-end trusts or hedge funds. In London, for example, Annaly partnered with Prodesse Investment Ltd., which trades on the London stock exchange (LSE: PRD) and buys mortgage-backed securities (MBS).

"We set up the investment structure through hedge funds looking for yield associated with MBS," Farrell says. "And yield is hard to come by in today’s market, so this provides a way to access yield."

Foreign expansion is another option for those mortgage REITs looking to do business abroad. REITs that expand their operations abroad essentially facilitate the flow of mortgage capital between a country with REITs and one without REITs. Fortress Investment Group, LLC manages global investments through several company affiliates, including Newcastle Investment Corporation (NYSE: NCT) in the United States and Eurocastle Investment Ltd. in the United Kingdom.

However, those U.S. REITs with overseas affiliates are not always doing business with countries with a REIT compatible market. In Italy, for example, there is a capital gains tax on all property sold within five years of purchase. And in France, there is an annual wealth tax on French assets of more than 720,000 euro (about $888,000 U.S.).

In the U.K. specifically, Dever says Eurocastle found a way around the absence of a REIT-like vehicle by using a Guernsey offshore trust. Guernsey is an island located off the coast of France that does not belong to either the U.K. or the European Union, but rather is a British crown dependency; it is autonomous and governs itself with its own domestic laws, including low taxes. Guernsey trusts operate through the Channel Islands Stock Exchange. The Jersey Isle, located between the United Kingdom and France, is another tax haven whose trust structure is similar to Guernsey.

Annaly also utilized an off-shore trust when working in the U.K. with Prodesse. "Prodesse is not a REIT, but a similar structure that operates out of the Channel Islands. Even though it doesn’t operate as a REIT, it operates the way a REIT would, with many of the same tax advantages," Farrell says.

Others say the benefits of an off-shore trust include the ability to defer or minimize the tax on investment income, insulate against litigation and bankruptcy and minimize business or corporate taxes resulting from international business activity.

Simon Clark, head of European real estate at Linklaters, an international law firm, says "Guernsey property companies" have been used in the U.K. as surrogates for a REIT. "The Guernsey [property company] pays only 22 percent on rent and no tax on capital gains. It creates a vehicle that is closer to a REIT," he says.

Clark says that using Guernsey property companies as a vehicle for U.K. investment is a popular strategy, especially as the country has not yet adopted its own REIT-like structure. However, he says he believes it will be phased out when the U.K. creates its own permissible REIT.

Preparing for the Future

Legislation, such as that authorizing creation of a REIT structure as well as standardized asset securitization, is needed in more countries to facilitate cross-border flows of mortgage investments. However, only time will tell what influence pending regulations will have on the market, and how such changes will affect deals that have already taken place. Farrell, for one, is optimistic that mortgage REITs will expand soon just as the globalization of equity REITs is happening now.

"In the next 10 years there will be a more robust market for global lending and underwriting, and large pools of capital will flow back and forth," Farrell predicts.