Dottie Cunningham, CEO of the Commercial Mortgage Securities Association, agrees, adding that the impact of CMBS cannot be overstated.

"CMBS has helped attract a broader range of investors to the commercial mortgage market, providing more capital for borrowers at competitively priced rates."

"From its beginnings, CMBS has proven to be a safe and viable investment product," Cunningham says. "The extraordinary and rapid growth is a testament to the liquidity and structure of CMBS and provides investors with one of the market's most transparent investment opportunities. With yields that are attractive compared to other investment options, such as corporate and other asset-backed securities, investors' appetite for this product is high, resulting in more than $160 billion in issuance last year."

Lowering the Cost of Capital

A large and liquid market for securitized real estate debt and equity helps to lower the cost of capital for REITs and other owners of commercial real estate by altering the way rating agencies evaluate the commercial real estate business.

As managing director of real estate finance with Moody's Investors Service, John Kriz says that securitization creates discipline, transparency and liquidity, all of which are valued by investors.

"These characteristics produce more efficient markets with lower betas, a measure of volatility," Kriz says. "Lower volatility tends to be associated with lower risk, which is another factor that can help to lower the cost of capital."

An Industry's Rise And Fall

REITs have been buying and managing real estate on behalf of their stockholders for almost 50 years. But the industry began to grow as a mainstream investment option only over the past 15 years.

President Eisenhower signed legislation allowing for the creation of REITs in 1960. The legislation aimed to give small investors a way to invest in income-producing real estate that they could not afford to own and manage on their own.

Between 1960 and 1990, REITs grew slowly. For most of that period, REITs were prohibited from both owning and managing their own real estate. Thus, third parties were hired to supply management services. However, investors shied away because they were concerned that the economic interests of third-party managers might differ from those of REIT management and shareholders.

Still, by the 1980s, REITs were beginning to come of age. In 1980, for example, Martin Cohen started the first commingled fund in real estate stocks for Citibank. Five years later, Cohen and Robert Steers joined forces and started the first real estate mutual fund. Today, their company, Cohen & Steers, Inc. (NYSE: CNS), manages a number of real estate funds and has more than $21 billion in assets under management.

Cohen points to 1986 as a key milestone in the history of securitized real estate and REITs. In that year, tax reform legislation altered the landscape of how the real estate industry operated.

"The Tax Reform Act of 1986 eliminated the tax shelter benefits of owning real estate through partnerships," Cohen says.

As a result, economics instead of tax law began to govern real estate development and investment decisions.

The 1986 Tax Reform Act also removed restrictions that prevented REITs from operating and managing their properties, at last bringing the economic interests of owners and property managers into better alignment.

"The law changed the model from one of external advisor to one where the company could manage its proper ties internally," Cohen says. "A REIT could finally control its own destiny."

An economic need for REITs and a securitized real estate industry was growing dramatically by 1986, but the forces driving that need were in large measure operating under the radar.

Out in the field, competition was fierce. Foreign investors, banks, and most of all savings and loans were pouring cash into real estate. Nearly every segment of the market was being overbuilt.

Then in 1989, Congress enacted the Financial Institutions Reform Act, which reduced the ability of banks and savings and loans to invest in real estate. "Essentially, we had a savings and loan crisis precipitated by unregulated lending by banks and savings and loans," Cohen says. "In 1989, Congress and the banking regulators limited how much these institutions could lend to real estate. This led directly to a capital shortage."

Zell calls the capital shortage the most significant single event in the history of REITs. "All the dedicated lenders and participants in real estate disappeared," he says.

Owners couldn't get the cash to finish projects. So they couldn't sign tenants, and they couldn't repay their mortgages. Prices plummeted, and they couldn't sell out. By some estimates, commercial properties lost between 30 percent and 50 percent of their value.

REITs Rise Again

In the early 1990s, the real estate industry found the answer to the capital shortage and helped lift commercial real estate out of what had become a major depression. The answer: securitized debt and equity.

"As an industry, we were forced to go from a limited number of people in a private environment to the discipline of a public market," Zell says. "I think that was extraordinarily positive for the U.S. economy. And I think it was very positive for real estate values in general."

A group of pioneering executives raised funds to buy distressed property, including property from the Resolution Trust Corporation (RTC), the government entity created to take over failing savings and loans and to dispose of the assets, including commercial real estate.

"The RTC was selling commercial real estate for pennies on the dollar," says Raymond Mathis, associate director, U.S. Equity Research with Standard & Poor's.

First, $1 Trillion U.S. Next, The € Successful CMBS and REIT markets in the U.S. have given rise to a worldwide movement of securitized commercial real estate debt and equity. Europe, for example, has traditionally been considered a banking market for commercial real estate. "Recently, the European market has begun to embrace CMBS," says Fraser Hughes, research director with the European Public Real Estate Association (EPRA). A recent report from Moody's Investors Service estimates that $40 billion to $47 billion in CMBS issues came to market in Europe during 2005, double the figure for 2004. Estimates for 2006 put the European CMBS market at $60 billion, compared to the relatively mature U.S. market that ended 2005 with about $100 billion in CMBS issues. "In addition, Australia has become a relatively liquid CMBS market, and a J-REIT in Japan recently issued its first CMBS," says Scott Crowe, global head of real estate research for UBS. Crowe also puts the equity market capitalization of REITs and non-REITs outside of the U.S. at approximately $437 billion. Approximately 20 countries have now adopted REIT business structures, according to a UBS Investment Research publication called the Global Real Estate Analyzer. Published at the end of 2005, the Analyzer identifies countries with REITs to include: Australia, Belgium, Canada, France, Hong Kong, Japan, Korea, Malaysia, The Netherlands, Singapore, Taiwan, Thailand, Turkey, and the U.S. Already in 2006, the United Kingdom issued REIT legislation to be effective on Jan. 1, 2007, and plans are underway in Germany as well. "We are at the start of a multi-decade trend toward real estate securitization, which is the biggest asset on the corporate balance sheet," Crowe says. "At the moment, real estate's total, global equity market capitalization of $767 billion accounts for about 3 percent of equity markets. I believe that this number will reach 10 percent within 20 years. Crowe adds that Japan and other Asian countries new to REITs have started pretty much where the U.S. started—with plain vanilla REITs—in 1960. In Europe, however, the property markets have grown liquid and deep in the un-securitized environment. As a result, Crowe says that European countries appear to be moving into the REIT era with structures already as sophisticated as those in the U.S.

Mathis adds that there was a fear of real estate investment at the time and the visionary property executives were able to capitalize on it.

"They saw that they could buy properties at a fraction of construction costs, understanding that they would eventually get full value back," Mathis says. "It was fortuitous for them. But buying real estate back then was also risky. It required foresight. Most of all it required conviction."

The times also led to the invention of UPREITs. When real estate owners formed REITs, they placed their real estate into the REIT in exchange for stock. However, the Internal Revenue Service (IRS) considered such an exchange a sale and a taxable event for the seller. Owners wanted to form REITs, tap the public markets, and buy real estate. But they hesitated at the prospect of receiving huge income tax bills related to the use of property to capitalize the REIT.

In December 1992, Robert C. Larson, currently the chairman of United Dominion Realty Trust (NYSE: UDR), was with the Taubman Realty Group, a partnership. "We were looking at the alternatives for entering the public market, and this tax issue was a major impediment," Larson says.

Larson and the Taubman team found a solution in the umbrella partnership REIT or UPREIT, an approach that permits a real estate owner to, in effect, contribute property to a partnership with the REIT without creating a taxable real estate exchange. Instead, the REIT and the real property contributor receive a form of property called partnership units for the property. As in a 1031 exchange, when one property is traded for another of equal value, the taxable event is deferred. Partnership units could be held indefinitely or exchanged for REIT stock at any time on a one-for-one basis, with any subsequent transaction considered taxable.

With UPREITs in place, a wave of REITs issued initial public offerings during the early and mid 1990s, launching what is known as the "Modern REIT Era" and bringing the commercial real estate industry back to solvency. The REIT contributed the cash it received in the IPO to the operating partnership, which paid down debt or acquired new assets.

"The invention of the UPREIT structure was pioneering and important to getting REITs going again," says Michael Fascitelli, president of Vornado Realty Trust (NYSE: VNO) and a partner at the time with Goldman Sachs. "REITs had a checkered past. Years before, most REITs were mortgage REITs that made construction loans. When the real estate markets tanked in the 70s and again in the early 80s, those REITs were caught with a lot of bad loans."

By this time, CMBS loans had begun to take off. According to Commercial Mortgage Alert, CMBS issuances in the U.S. jumped from about $3.4 billion in 1990 to $15.7 billion in 1995. CMBS borrowing continued to grow through 1998, when the industry issued $74.3 billion in these securities. Real estate debt securitization dropped off over the next couple of years, but rebounded in 2003 to $77.8 billion. Estimates for CMBS issues in 2005 come to a whopping $169.2 billion, with current outstanding CMBS issues holding at just less than $700 billion. CMBS issuances make up 26 percent of commercial mortgage debt outstanding.

A contributor to CMBS growth has been the creation of Real Estate Mortgage Investment Conduits (REMICs), an industry adaptation from the Tax Reform Act of 1986. REMICs are investment grade mortgage bonds and most CMBS transactions are structured in this format. Jamie Woodwell, senior director of commercial and multifamily research at the Mortgage Bankers Association, calls them a "guide" to the CMBS market.

"What you've got with REMICs is a place where pools of mortgages are brought together and tranched, and the cash flows that are coming in from the pools are sold off to investors," Woodwell says.

"What the growth of the CMBS market has done is made commercial real estate mortgages available to the broader capital markets, just in the same way that REITs have made investing in commercial real estate available to the broader capital markets," he continues.

While the CMBS growth path was relatively unobstructed, REITs faced a number of issues. Prior to 1993, for example, pension funds were limited by something called the "five or fewer" rule. Under this rule, five or fewer individuals were not permitted to own more than half of a REIT's stock, with a pension fund being considered one individual.

The rule prevented pension plans from accumulating large positions in REITs. Institutional investors typically invest large dollar amounts. Because institutions such as pension funds were considered single investors, however, they could not invest amounts considered worthwhile in REITs.

The Revenue Reconciliation Act of 1993 remedied the problem by declaring that pension funds would be viewed as a collection of beneficiaries instead of a single entity. To prevent institutions from gaining too much control over individual REITs, provisions in the law set limits on how much stock pension funds could own.

Commercial real estate was on its way back. But hurdles remained. While institutions could invest in REITs, would they? Did their advisors believe that REITs offered an investment alternative capable of making a contribution to institutional portfolios?

"In the middle of the 1990s, institutions viewed REITs as little more than interesting niche companies with no track record," says Ralph L. Block, a REIT investment strategist for Phocas Financial, an equity investment manager for institutions and individuals. "Institutions thought REITs were run more like private fiefdoms than public companies. They looked but didn't really want to do business."

Not just yet.

REIT Modernization

The emergence of REITs helped commercial real estate to recover from the severe industry depression of the early 1990s. The Tax Reform Act of 1986 had given REITs important property management tools. The growth of CMBS in the early 1990s added debt investors to the equity investors that owned REITs. UPREITs gave large owners an economical way to form REITs. The Revenue Reconciliation Act of 1993 enabled institutions to invest more effectively in REITs.

By the end of the 1990s, growth of the REIT industry had been constrained by lagging REIT stock prices, thanks in particular to the growing dot-com bubble. REITs weren't flashy enough to compete with high-flying, high-tech companies.

But REITs did manage to gain additional operational flexibility under the REIT Modernization Act. Passed in 1999 and set to take effect in 2001, the legislation allowed REITs to own Taxable REIT Subsidiaries (TRS), in part to compete effectively in the marketplace of services offered to tenants.

Among other things, TRS may handle services such as landscaping, cleaning, maintenance, and other services expected to be provided by landlords.

All subsidiaries must not exceed 20 percent of a REIT's assets, while income from a TRS must be counted as "non-qualified" income, which cannot exceed one-quarter of the REIT's total revenues.

The Stress Test

In 2001, just as REITs assumed full control of their operations, the economy fell into recession, the first ever faced by most modern REITs. Real estate fundamentals suffered, as they always do during a recession.

"This was a significant milestone for REITs," says Fascitelli. "REITs and hard assets like real estate were out of favor during the dot-com boom. But people in the business kept their heads down, remained disciplined, and did the right things. They didn't over-

leverage their companies. They didn't make stupid acquisitions. They didn't reach for yield. They didn't diversify into businesses that were more risky. They stuck to their knitting, even though their knitting was out of favor.

"Before the recession, the open question was, could REIT leaders become effective leaders of public companies and good stewards of capital? Since the recession, I think they have shined in both areas."

Others have begun to recognize REIT capabilities as capital stewards. "Eleven REITs have now been admitted to the S&P 500, whereas before 2001 they were excluded," according to R. Scot Sellers, NAREIT chair and chairman and CEO of Archstone-Smith (NYSE: ASN). "The major media now include REITs in their annual rankings and awards. Last year, Fortune named us (Archstone-Smith) one of the 50 best employers for minorities in the country. Equally important, investment research has substantiated that owning REITs is a critical component of a well-diversified portfolio, which improves overall returns and also reduces overall risk."

"The industry has continued to mature, and with that maturity has come acceptance," Woodwell says. "You've got the general acceptance of commercial real estate as an investment and asset class, and you've also got a lot of transparency so that investors and rating agencies can dig into where the properties supporting these investments are and where the payment stream is coming in."

That transparency has translated into recognition from the world's leading proxy advisory and corporate governance ratings service, Institutional Shareholder Services (ISS). In its Corporate Governance Quotient ratings released in April 2005, and again in April 2006, ISS found the REIT industry second (only to the utilities industry) among 24 industries in the quality of its corporate governance.

Also, since the recession, REITs as an investment have outperformed the broader stock market every year for six straight years. With that, many institutional investors that once shied away from REITs have changed their minds and begun to form partnerships with REITs.

"These partnerships will buy, manage, and sometimes develop real estate," Block says. "This is the newest business model REITs are using to build shareholder value. What has enabled REITs to play this kind of larger role in the world of commercial real estate is their larger size."

Call it the $1 trillion effect.