Banks in good position to capitalize on the current popularity of REITS.

Banks may be helped with their thornier real estate problems by an interesting paradox that has unfolded on Wall Street.

In the mid-1980s, with both real estate and the stock market approaching new heights, the time looked right for a boom in real estate investment trusts (REITs). Unlike limited partnerships, REITs offered investors a chance to participate in real estate without sacrificing liquidity or worrying about the IRS challenging the tax shelter element.

But the boom never occurred. Although many publicly traded REITs were established, usually with generous current yields, most REIT shares were consistent underperformers in a surging stock market. Wall Street never truly got behind REITs, remaining skeptical of the high values assigned to their underlying assets.

Now for the paradox: With real estate in a deep slump today and the stock market lodged on a plateau, REITs suddenly have found new respect on Wall Street. It's hardly a mystery, however: Investors are starved for high yields, and property owners are desperate for ways to reliquefy. And there is a general perception that real estate has nowhere to go but up, even if not immediately. Thus, the REIT now flourishes.

What does this mean to banks? The strong link between real estate and banking suggests several ways in which lenders can take advantage of the REIT's rebirth. For one thing, would-be REIT sponsors hold great promise as potential buyers of banks' higher-grade foreclosed real estate.

The reason is that many real estate owners with midsize portfolios would love to recapitalize with a REIT but lack the critical mass to satisfy the investment banks. Generally, Wall Street won't look at a portfolio much below $150 million, nor will it allow a sponsor to meet the minimum by acquiring junk.

Motivated Buyers

This turns potential REIT sponsors into highly motivated buyers. They are looking for deals in which they can finance the purchase at two or three points below their cap rate on the property, which, under current conditions, leaves room for somewhat better-than-average prices for the seller.

The assumption is that a successful REIT offering - made possible in part by the acquisition - will allow the sponsor to pay off existing debt and restore a healthy balance sheet.

Therefore, banks with quality foreclosed realty, especially multifamily housing and retail, should be aggressively marketing to midsize property owners.

Of course, banks also can help would-be REIT sponsors by financing acquisitions from other types of sellers. The same logic applies: The lender will add a quality loan to its portfolio if the borrower is comfortably below its cap rate and can pay off debt by selling stock.

But there are two big underwriting caveats: Be sure the property is a high-grade investment and look for ownership that has recognized professional management skills. Wall Street is less likely to bring to market a REIT that lacks either of those attributes.

A third way for banks to participate in the REIT boom is by offering credit lines to existing trusts for new acquisitions. This can be a prudent and profitable activity, since the mortgages are cross-collateralized, and lenders can still dictate conservative loan-to-value and debt-service-coverage provisions.

Some lenders might wonder if banks might themselves be sponsors of REITs, packaging their better-quality REO for Wall Street's consideration. The answer, I believe, is no - at least not for the time being.

Continuity of Management

Investment banks look on REIT formation as the act of recapitalizing an existing business with continuity of management. Even if a bank hired a top professional manager for its proposed REIT, that probably wouldn't satisfy Wall Street's insistence on management with a history tied to the core of the property portfolio.

Therefore, an, equity REIT formed by a bank for the purpose of property disposition is unlikely anytime soon. (However, insurance companies that traditionally have owned and operated real estate equity portfolios may be in a better position to sponsor an equity REIT).

Mortgages, on the other hand, may present a different picture, since there is no property management factor. Lenders might want to consider restructuring selected mortgages, adding equity participation features, and sponsoring a publicly traded REIT to which the loans would be sold.

These are some of the ways in which banks can benefit from the new interest in REITs. Of course, a spike in interest rates would hurt REITs in the short run.

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