Quick Bio: Brent Ambrose is the Jeffery L. and Cindy M. King Faculty Fellow in business and professor of real estate at Penn State University. He has authored approximately 40 papers on a variety of real estate topics, with a special concentration on mortgage finance during his 18-year academic career.

By Brad Case

Portfolio: Mortgage REITs of all types were hurt by the problems in the subprime residential mortgage credit industry. What do you think the future holds for investors in mortgage REITs?

Ambrose: The fallout from the subprime crises is being felt worldwide, and mortgage REITs are no exception. However, investors will be in a position to better evaluate the risks associated with individual mortgage portfolios once more information about the extent of the problem in residential mortgage underwriting becomes available.

The current problem is that investors do not have sufficient information on the risks associated with mortgage portfolios, and risk premiums reflect that lack of confidence. Mortgage REITs holding portfolios of Fannie Mae- or Freddie Mac-backed mortgage securities have portfolios with significant credit enhancements that will protect investors from a severe downturn in the housing market.

However, as the turmoil in the credit market this summer demonstrated, I would be concerned with any type of specialty finance company using a strategy of financing long-term assets, such as long-term mortgages with short-term debt.

Portfolio: Is it possible that mortgage REITs will emerge from the credit crisis in a stronger position relative to other holders of mortgage assets, just as equity REITs emerged from the 1989-1991 real estate crisis in a stronger position relative to other real estate investors?

Ambrose: Certainly, it's possible. The mortgage REITs that survive will be the ones that have access to capital, allowing them to pick portfolios from other investors that were forced to sell. As a result, the survivors will be stronger.

Portfolio: Many investors have noticed a recent uptick in the return correlation between REITs and the broader stock market. You found the same effect, as a result of the inclusion of REITs in the S&P 500 and other broad stock market indexes. Do you think that higher correlations and higher betas are likely to continue as index investing remains important, or are they likely to fall again as investors increasingly recognize REITs as a separate asset class?

Ambrose: Index investing is one of the major innovations to be developed from academic research on investments, and the growth in market index funds is proof that this concept is now regarded as mainstream. As a result, index investing will continue to grow. As REIT market capitalizations increase and become a larger part of the stock market, it is only natural that REITs will be incorporated into the broader market indexes.

Even if investors see REITs as a separate asset class, REITs will continue to become a larger part of the overall market capitalization and higher correlations and betas are likely to continue. However, the correlations between REITs and the broader market were low to begin with, and we documented only a modest increase.

Portfolio: REITs were once required to hire external advisors, but your research found that internally advised REITs outperformed externally advised REITs. Do you think that permitting REITs to self-advise and self-manage has been a significant factor in the success of REITs since that legislative change?

Ambrose: Yes, I think it is clear that the move to an internally advised structure fundamentally altered the REIT landscape. The internally advised status helps reduce the effects of conflicts of interests between REIT shareholders and management from a corporate governance perspective.

The internally advised status provides a greater incentive for management to operate efficiently. Additionally, the internally advised structure removed the concerns of original developers and operators that they might lose control of their properties following conversion to public REIT status.

Portfolio: You even found that internally advised REITs had higher betas. Why would that be?

Ambrose: You are referring to a study that Peter Linneman and I conducted where we found that internally advised REITs had higher betas in 1995 and 1996. Basically, the higher betas reflect the market perception that internally advised REITs are more like traditional operating companies and thus carry greater risk than the old-style, externally advised REITs that were passive investment entities. We conjectured that the internally advised REITs were sufficiently new that the market viewed them as more like "growth" stocks at the time.

Portfolio: Are REITs part of your investment portfolio?

Ambrose: Yes, they are. However, as an academic financial economist, I try to practice what I preach by investing in a low-cost, REIT index mutual fund as part of a tax-deferred account.