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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