In my last article (see related stories), I said that I believed European commercial mortgage-backed security (CMBS) was not the new thing.
However, I need a new thing. What about REITs? They may be the vehicle that can recapitalise the challenged European property markets.
I have been in debt for 25 years (not personally, but the debt capital markets). Now I wonder if I should have a closer look at equity. The mortgage REIT has become the new ‘new’ thing that seems to be arbitraging. When I first read the book Antifragile, I did not accept the author Nassim Nicholas Taleb’s view that equity is robust and debt is fragile. But now I am considering the argument.
When times are good, debt, as the highest ranking piece of the capital structure, appears to insulate against risk. But perhaps low-leveraged REITS may protect from cycles better and be the most authentic way to invest in the sector.
REIT shares allow investors exposure to the overall performance of the property sector. A REIT’s performance is tied to the performance of the company’s physical assets, typically in a specific sector (but not always), and is easily traded, at least versus direct property. What makes a REIT special is that the company must dividend a minimum of 90% of its qualifying income to shareholders in order to benefit from favourable tax treatment. REITs, I think, are a tax-efficient way to run a property company by passing the tax obligations down to the underlying investor.
Currently, the market for raising equity for equity property companies seems healthy. Kennedy Wilson has just raised £1bn of equity (Kennedy Wilson Europe is not a REIT — it is a Jersey-listed plc, but has agreed a standard dividend policy). Two weeks ago, Merlin Properties announced an IPO for more than a €1.5bn to invest in Spain - the largest ever real estate IPO of a real estate company in Western Europe. A wave of interest in real estate sourced from the equity capital markets is the big story. Listed investors have seen private equity making hay in this way and want a piece of the action. This makes a lot of sense.
However, the ‘REITs’ listed above buy and sell real estate, but we are seeing REITs with an objective to be a lender. The “mortgage REIT” sounds like an oxymoron and makes me smile. Okay, it may not be as amusing as others such as “fresh-frozen”, “deliberate mistake”, “original copies” but it is still a bit of contradiction in phrasing. Is this a product for the former CMBS investor or for equity investors? The worlds of fixed income and structuring have collided with blind pools and capital gains.
REITs are real estate operating companies, but mortgage REITs lend and take the place of speciality finance companies. What makes them very interesting is that they seek to arbitrage different parts of capital markets. No more focus on secured lending as the channel for funds. No more looking for accumulation lines to be taken out by ratings and structuring. There are road shows, book builds and then cash to spend.
Starwood, at a market capitalisation of £2.6bn, and Blackstone, at £930m (and has originated £2.3bn of loans) are mortgage REITs, and while US listed, they can and are investing (by lending) against European properties. They chose the REIT route instead of securitisation because it is permanent capital.
The mortgage REIT money comes with the flexibility to invest, low cost and the challenge of reporting and performing as compared to shares of other companies. Premium to book replaces cash-flow analysis and permanent capital replaces financing. Gearing through CMBS meant the property company was transferring risk to the bond market. Bond buyers (or lenders) believed that structural protections such as waterfalls, reserves and subordination were the tools that matched risk to return.
By investing in a mortgage REIT, an investor is providing capital while requiring a dividend and, through capital gains and NAV appreciation, hoping for a return. Return is predicated on successful management, macro conditions and liquidity. While not simple to forecast, it seems less complicated than CMBS.
Private equity has been doing all this for years. But public equity is having a bigger role and the oxymoronic mortgage REIT is taking it a step further. Mortgage REITs could be the better CMBS. However, this begs the question whether the equity markets will fuel growth and then fuel a crisis. At least next time we won’t blame debt.
For those who were kind enough to read to the end, but still have no idea why I find the term ‘mortgage REIT’ funny, you will at least understand this one, the oxymoron of the property world: ‘free rent’.
Ellen Brunsberg is managing director of GE Capital Real Estate