By Courtney Darby

Equity REITS explore structured finance opportunities as mortgage REITs welcome the competition

Equity REITs have traditionally been defined as entities that primarily own portfolios of properties. However, in an effort to increase shareholder value and utilize management's real estate finance knowledge and skills some equity REITs have begun to implement a real estate finance strategy to complement holding properties. This is not a new phenomenon in the REIT industry—beginning in the 1960s triple net lease REITs practiced financing as well as owning triple net leased property, while starting in the 1980s health care REITs tried their hand at mortgages. Over time, some equity REITs have begun to further broaden their horizons by servicing their clients with structured finance (loans, commercial mortgage-backed securities, debt, etc.), an avenue some say could lead to a lot of gray areas and potentially impact the mortgage REIT sector.

"More equity REITs are asking, 'where is the opportunity and where can I put capital to work?' As a result, they are increasingly looking to the debt side of the business," says Paul McDowell, chief executive officer of Capital Lease Funding (NYSE: LSE), a mortgage REIT with a strong presence in structured finance. "However, the risk is a lack of discipline in the market. If you get in the debt business and don't know what you're doing or are unable to make sound judgements, your business is at stake."

According to Don Fandetti at Wachovia Securities, senior real estate research analyst for mortgage REITs at , it has only been within the last year that equity REITs have really begun to explore the structured finance business.

"Generally, equity REITs stick with their core business of buying properties. Equity REITs think that with low cap rates they can supplement their investment pipeline with mezzanine loans, CMBS, etc. The returns on those can be attractive, which is why we are seeing more of it," Fandetti says. "[Companies] focus on what they think the best business model is and exercise that in the REIT format."

For example, Vornado Realty Trust (NYSE: VNO) made a $275 million mezzanine loan secured by a partnership interest in the General Motors Building in New York. "As value players we are always looking for the appropriate risk-adjusted return, the GM building is a perfect example," says Wendy Silverstein, executive vice president of capital markets, at Vornado's 2004 Investor Conference on Oct. 5.

"We are seeing a modest number of equity REITs dabble in real estate securities investments, both as a way to earn a higher short-term return and as a way to possibly acquire the asset itself down the road (should the borrower encounter difficulty)," says Lisa Sarajian, managing director in Standard & Poor's real estate finance group. In addition to Vornado, Sarajian says other equity REITs that have been active in this area include Health Care Property Investors, Inc. (NYSE: HCP), Camden Property Trust (NYSE: CPT), Kimco Realty Corporation (NYSE: KIM), SL Green Realty Corporation (NYSE: SLG) and CenterPoint Properties Trust (NYSE: CNT).

Thinking Outside The Box

While a strategy can be executed several ways, some companies, depending on their management teams and investment strategy, are more prepared to venture out of the traditional equity REIT box.

"Companies like Vornado Realty Trust and Crescent Real Estate Equities Company (NYSE: CEI) are more prepped to go beyond just property acquisitions because of their strong management and experience," says Greg Whyte, managing director at Morgan Stanley.

Lodging REIT Ashford Hospitality Trust Inc. (NYSE: AHT) is another equity REIT that has expanded beyond the traditional business model.

"Our mission is to be the premier provider of capital to the lodging industry. In order to be different from our peer group, who typically focus on one strategy, we wanted a more unique and diverse investment plan," Doug Kessler, Ashford's chief operating officer, says.

Ashford's core business is comprised of not only owning and operating hotels, but also providing first mortgages, sale leasebacks and mezzanine loans to hotels.

"We vary our concentration depending on how we need to react to the current cycle we are in," Kessler says. "Typically our capital represents 10 percent to 14 percent in mezzanine loans, 60 percent to 90 percent in direct hotels and then selectively in first mortgages and sale leasebacks—each is a very attractive opportunity depending on where the cycle is."

According to Kessler, Ashford tries to have an overweight position based on market conditions. For Kessler, the challenge is knowing when and where to allocate that capital.

"During March 2001 there was a recession and equity REITs in the lodging sector performed poorly, whereas mortgage REITs performed significantly better," Kessler says. "You have to allocate capital at different parts of the cycle and it is a challenge to find a management that can execute that."

Kessler notes that Ashford has been able to do well in both the equity and mortgage side of the business primarily because of its management team.

Not only does management play an important role, so do flexibility and a willingness to modify business strategies. McDowell, like others in the REIT industry, believes that in any good business change comes with the times.

"In any business, if you're unwilling to adjust as conditions change, you disappear. The real estate business is subject to the same rules of nature as is larger corporate America," McDowell says.

According to Whyte, this extension of equity REITs is simply an outgrowth of core real estate competencies and management's desire to drive higher returns.

Betsy Cohen, chairman and CEO of RAIT Investment Trust (NYSE: RAS), a mortgage REIT that focuses on specialty finance, says that equity REITs are simply taking advantage of the opportunities the market has afforded them.

"The real issue is, do these equity REITs have the underlying system, mindset and management to be a good lender?" Cohen says.

In August, SL Green Realty Corporation launched Gramercy Capital Corp. (NYSE: GKK), which is strictly a specialty finance company. The structured finance program within SL Green was such a successful venture that the evolution of creating a specialty finance vehicle wasn't far off, according to Andrew Levine, SL Green's executive vice president. Prior to Gramercy, SL Green deployed up to 10 percent of its capital in structured finance.

"There were two driving reasons to launch Gramercy. First, it was good for earnings, and, secondly, it provided a potential acquisition pipeline," Levine says.

Levine explains that when the party you financed is looking to sell its building, you're first in line for that asset, which can make a huge difference if your market is sparse for acquisitions.

Convincing Investors

As equity REITs continue to think outside the box and find creative ways to deploy capital, they've also had to be proactive at convincing investors that this new extension is a worthwhile endeavor.

"It is logical that some of the more savvy equity REITs can supplement their investment pipelines with lending, as it helps some companies maintain growth," Fandetti says. "Although, most investors wouldn't want to see a large scale convergence into lending and owning."

According to McDowell, the biggest barrier for equity REITs entering the structured finance business is expertise. McDowell says that traditionally a "simple story" has been what is needed to sell investors, and to some degree, the story can't have too many moving parts.

"[When you enter into the mortgage/finance side] it is a story that takes a lot of explaining—mortgage has several moving parts," McDowell says. "The debt and equity equation is a complex business model. It's not necessarily riskier, rather it just takes more time for investors to understand how it works."

Donald Destino, managing director and senior analyst of specialty finance at JMP Securities LLC, notes that the biggest hurdle equity REITs encounter is a perception issue.

"The strategy for equity REITs is to garner returns from lending without the label of a 'hybrid' or 'mortgage' REIT. Equity REITs want to downplay their entry into lending so it will be viewed as opportunistic," Destino says. "Traditionally, equity REITs have traded at a premium to mortgage REITs. You have to convince investors that you deserve the same multiple as before, but with additional earnings."

Levine says equity REITs need to make sure their investor base is comfortable with the move into structured finance.

"You have to look at what it costs to raise money in the equity market and what you can borrow in the finance market. As an equity REIT, you also have to be confident that you can lend out the money in a manner that is cost efficient," Levine says. "Management must show its shareholder base that the company is dedicated to the same thought process for an equity investment as it is for a debt investment. If you show the same energy and thoughtfulness on both sides of the equation, more investors will be comfortable with that."

Cohen adds that the prospective equity REIT management team needs to view structured finance as a business, rather than a one-day venture or "flight of fancy."

"This is a business and you have to treat it as such," Cohen says. "You must convince your investor base that you have both sets of skills for both markets. You also have to show that you are an owner of properties who can exercise day-in and day-out judgement calls for the structured finance side."

Levine also advises that it is important to stick with your niche market.

"You have to identify what investors see as your 'sweet spot.' For SL Green, that sweet spot is in New York, whether that be acquiring in that region or making loans there," Levine says. "If we start making loans outside of our 'sweet spot,' investors are uncomfortable."

Walking The Line?

Gradually, as more equity REITs begin to take on mortgage REIT-like activities, the distinction between the two could potentially change over time.

"It clearly blurs the definition of an equity REIT," Fandetti says. "You'll see more blurring as equity REITs combine activities going forward because investors have gained a comfort level with lending activity, due to low default rates."

According to NAREIT's definition, in order to maintain equity REIT status, a REIT must have 75 percent or greater of its gross invested book assets in income-producing real estate. A mortgage REIT must have 75 percent or greater of its gross invested book assets in mortgages. If the REIT doesn't fall into one of those categories it is considered a "hybrid REIT."

Levine notes that the accepted definition could shift, but does not believe the notion of an equity REIT will become significantly altered.

"As equity REITs start to branch out and find other types of investments, you may find that just calling something an equity REIT might not work," Levine says. "While the definition will start to blur, as equity REITs are supposed to be 'one-dimensional animals,' market and management limitations likely will control how far equity REITs can go on the mortgage side."

Structured Finance 101 When equity REITs venture into the realm of structured finance that can involve various types of transactions depending on the respective REIT's investment strategy. Listed below is basic terminology for the common transactions that occur in structured finance. A Note Within a mortgage note structure it's known as the senior tranche of the mortgage, and in a securitization it is the portion of the note given an investment-grade rating. B Note Within a mortgage note structure this is the junior tranche of the mortgage, which is generally below the investment grade. Commercial Mortgage-Backed Securities (CMBs): A sub-set of mortgage-backed securities, but are backed only by loans secured with commercial property rather than residential property. Commercial property typically includes multifamily, retail and office. First Mortgage The senior debt instrument encumbering real estate, which gives the holder of the instrument a first priority lien over all creditors (other than for real estate taxes and certain contractors providing materials and labor to the real estate). Mezzanine Loan That portion of financing which is not secured by a mortgage, but rather is secured by pledges of the equity interests in the borrowing entity. Mortgage-Backed Securities (MBSs) Securities backed by a pool of mortgage loans that secure any type of property (commercial, residential, etc.). Preferred Equity Investment That portion of the capital stock represented by an equity investment in the ownership entity, which is senior to the common equity. The preferred equity typically doesn't have an ownership interest or stake in the investment (unless there is a "kicker" or participation interest), which is usually reserved to the common equity. Straight Debt The term "straight debt" means any written unconditional promise to pay on demand or on a specified date a sum certain in money if the interest rate (and interest payment dates) are not contingent on profits, the borrower's discretion, or similar factors and there is no convertibility (directly or indirectly) into stock.

While some are concerned, others don't believe that this movement into structured finance is one to be worried about.

"Only a handful of equity companies have really gotten involved in this business," Morgan Stanley's Whyte says. "We're a long way from graying the definition of an equity REIT."

Cohen says that this movement will likely be short lived, as equity REITs are taking advantage of a moment in the market.

"I don't think we'll see a wholesale move on the part of equity REITs into the structured finance business," Cohen says. "Lending isn't the only thing that has changed over the years. We've had the taxable REIT subsidiaries (TRS), management companies that formed under office REITs, amongst other changes. If anything, it poses more of a problem for the individual equity REIT, rather than the mortgage REIT sector as a whole."

Fandetti acknowledges that there is a buzz in the industry about equity REITs exploring structured finance, but he doesn't believe it will negatively impact mortgage REITs.

"Equity REITs do add to the downward pressure on returns we've seen in structured finance," Fandetti says. "They are not huge players, so it isn't material to the [mortgage REITs]."

McDowell views the new equity players as just another form of healthy competition for the mortgage REIT sector.

"Mortgage REITs with good management that are run well will meet the competition and they might make a transition toward actively acquiring properties," McDowell says.

Levine doesn't think that many of these ventures will have long-term staying power.

"Like any other business, a lot of equity REITs will get their feet wet and then find out it is not for them because it takes too much energy away from their core business and their investor base isn't comfortable with it," Levine says. "By virtue of this process you may find some select equity REITs that make the decision to go full scale into finance, but if they can't find a product it won't work out."

Whyte adds that it's quite possible this issue could go both ways, as more mortgage REITs could become proactive about dabbling in the equity side of the business. However, Cohen doesn't think that will happen.

"I do believe that if you're a lender in the specialty finance/ mortgage business you should remain primarily a lender, not an owner/operator of properties," Cohen says, adding that the specialty finance culture is a lending culture and that is what works well.

As equity REITs continue to explore new and unique ways to increase capital, this won't be the first or the last time they venture outside their traditional boundaries. Structured finance is currently seen as a viable expansion opportunity for equity REITs, but proactive management teams will always be on the lookout for new opportunities.