How debt becomes equity, REIT edition

By Felix Salmon
July 20, 2009

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.


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But the collateral will be worth much less than people think. There will be no appetite for an overbuilt commercial real estate market.

Not sure about institutional interest. REITs have historically behaved like small/medium cap value stocks. REITs don’t add much to a portfolio if it already contains direct property is small caps.

Posted by Alex R | Report as abusive

I agree. Having a new breed of REIT invest in CMBS issues and similar mortgage-linked debt is a positive development. Perhaps more positive than some people think. A lot of those CMBS issues are NOT going to default. CMBS issues are structured and underwritten somewhat differently than securities tied to subprime, ALT and jumbo residential mortgages.

But that’s the good news. The REITs will simply have more cash as CMBS market values rise.

Short-term, these “vulture debt REITs” look good. Long-term, I doubt they will be able to adapt after all the federal government’s “sweeteners” — overt and covert — are taken a way. My advice to retail investors: Take your gains and dividends and then get out after two years. Maybe sooner.


You are not correct…. You can’t buy CMBS securities and get your hands on the collateral. These are securities, not whole loans.

If you want to talk about it, I can show you.

this is the type of thinking that investors who have never been through a foreclosure use. even if the buyers of the cmbs can eventually get their hands on the collateral, and that is a HUGE if since the buyer will have to buy every tranch or convince other owners of the pool he has superior operational skills, the process and costs will eat away at profits more significantly than anticipated. it sounds easy, but it’s not.

Posted by david | Report as abusive

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.

Posted by David hogard | Report as abusive