How Debt Becomes Equity, REIT Edition

Phil Wahba and Ilaina Jonas report:

Several large investment firms are creating new lending companies that plan to go public to raise billions of dollars to take advantage of the distress in the commercial real estate market, and more are on the horizon.

The planned IPOs, which include units of firms like Apollo Management and Alliance Bernstein, could be just the beginning of what some bankers expect to be a boom in Real Estate Investment Trusts (REITs) going public over the next few years.

The U.S. commercial real estate market has been reeling ever since a prime source of financing, the commercial mortgage-backed securities (CMBS) market, virtually closed and banks shut off their lending spigots in the past year.

Essentially what’s happening here is that debt (in the form of CMBS) is being rolled over into equity (in the form of REITs). This is a good thing, and I hope we see much more of it.

This is a two-stage process, I think: first the REITs will buy up distressed CMBS at a discount, then they will wait for those CMBS to default, at which time the REITs will take possession of the collateral — the commercial real-estate securing the CMBS. In other words, the REITs — and the REIT investors — aren’t looking at yields, they are looking at property values.

It’s an open question, of course, how much leverage these new REITs will be able to use, and also whether the kind of institutional investors who used to invest in CMBS will ever have any interest investing in REITs instead. But I hope that the answers are “very little” and “yes” respectively. It’s a good idea for an investor to accept a bit of short-term equity market volatility if it means losing a lot of long-term tail risk.

Comments

[RE guru:]

Much, much, much easier said than done. CMBS bonds are a financial Rube-Goldberg contraption. It's possible that the equity owners come out ahead on the CMBS stuff. New proposed REMIC rules will allow services more latitude and making it much more challenging to get the borrower out (take over the equity) in a deal. If the bankruptcy-remoteness & springing recourse of the CMBS documents doesn't hold up in GGP and Extended Stay, look for more borrowers to default & file BK.

Jul 20 10:11 AM

[Patrick Harden:]

Let's look at the evidence from these new REITs' S-11 filings:

"We expect to use leverage, directly and indirectly through financing vehicles, to increase potential returns to our stockholders and to fund the acquisition of our assets." [Source: Foursquare Capital Corp. S-11 filing, page 9]

"We expect to use leverage to finance our assets through borrowings from repurchase agreements, to the extent available to us, borrowings under programs established by the U.S. Government such as the TALF and PPIP, and other secured and unsecured forms of borrowing." [Source: AG Financial Investment Trust, Inc. S-11 filing, page 46]

"Initially, we intend to deploy leverage on our target assets, on a debt-to-equity basis, of up to 1.0 to 1.0 on a portfolio basis. If we obtain financing under the TALF or any other U.S. Government programs, we expect to incur significantly more leverage. For example, with respect to the TALF, we expect to finance up to 85% of each of our eligible CMBS assets on a non-recourse basis. When market conditions allow, we intend to finance our first mortgage loans in part through the issuance of AAA-rated CMBS, which we expect should be eligible to be purchased by investors who are able to borrow under the TALF, while retaining the subordinate securities in our portfolio. " [Source: Ladder Capital Realty Finance Inc. S-11 filing, page 11]

I question the viability of these new REITs in my July 14 article: seekingalpha.com/artic...

These mortgage REITs are likely to have substantial taxable income in excess of cash available for distribution, forcing them to borrow more money under unfavorable market conditions or issue even more equity to satisfy the REIT distribution requirements.

Jul 20 11:43 AM

[Kinabalu:]

Patrick Harden

Your July 14 article refers to "market discount" as a significant negative for investments in distressed debt by creating taxable income without generating cash. There are significant arguments and strategies for avoiding such negative treatment.

Generally speaking, any time a bond has declined in value after its original issuance a subsequent purchaser who buys the bond from the original holder will be treated for tax purposes as holding a “market discount bond,” with the “market discount” being the excess of the bond’s face amount over the purchase price paid.

The tax code also provides that it is only the portion of the total market discount that is “accrued” as of the time of the pay off date that is required to be treated as taxable income. The tax code provides fairly detailed rules as to the manner in which this accrued market discount is to be calculated. The determination of this accrual for distressed debt, including 'demand' debt that is already in default, makes it fairly uncertain whether these rules were intended to apply to such debt at all. I would suggest you review the attached article from the Journal of Bankruptcy Law, particularly pages 30-34.

www.foley.com/files/tb...


On Jul 20 11:43 AM Patrick Harden wrote:

> I question the viability of these new REITs in my July 14 article:
> seekingalpha.com/artic...
>
> .....
> These mortgage REITs are likely to have substantial taxable income in excess of cash available for distribution, forcing them to borrow more money under unfavorable market conditions or issue even more equity to satisfy the REIT distribution requirements.

Jul 20 02:57 PM

[Rhino Realty:]

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Jul 20 10:40 PM