When Flagstar Bank in Bloomfield Hills, Mich., wanted to build capital, it did not simply sell more stock to the public.

Instead, the $2 billion-asset bank created a real estate investment trust called Flagstar Capital Corp. and sold securities in the new company.

Under a 1996 Federal Reserve Board ruling, banks may create separate companies that invest solely in the bank's own real estate loans. As REITs, the new companies are exempt from paying most federal taxes. Moreover, proceeds from the sale of so-called REIT-preferred securities can be counted toward a bank's Tier 1 capital, which it can then use to finance growth.

"This is a cheap form of raising equity, and it doesn't dilute the value of our common stock," said Michael Carrie, chief financial officer at Flagstar. It is expected to complete its $50 million offering in mid- February.

REIT-preferred securities first came into vogue in late 1996 when the Fed approved Chase Manhattan Corp.'s application to create a bank-owned REIT. While larger banks and thrifts-including Maryland's Chevy Chase Bank and California Federal Bank in Los Angeles-quickly followed suit, community banks have only recently begun to take advantage of this financing tool.

Among them: Franklin Bank in Southfield, Mich., which completed its $20.7 million REIT-preferred offering in December; D&N Bank in Troy, Mich., which established a REIT in July; and Peoples Bank of California in Los Angeles, which issued REIT-preferred shares last October.

"You have to be willing to invest a lot of time and effort to understand how these things work," said David F. Simon, chairman of $502 million-asset Franklin. "We looked at it for a long time before we finally pulled the trigger."

REIT-preferred securities help banks in three ways. First, the assets of the company go straight to the bank's bottom line. Peoples Bank's assets, for example, have increased more than $50 million, to $2.2 billion, since its REIT was created.

Second, as a REIT that pays out the bulk of its earnings to investors in the form of dividends, the subsidiary is exempt from federal income taxes.

And most important to banks, many of which are struggling with liquidity, the additional funds count as Tier 1 capital.

"We don't have a pot of gold in the back room to use for acquisitions," said George Butvilas, president and chief executive officer at $1.2 billion-asset D&N Financial Corp., D&N Bank's parent.

After completing its REIT-preferred offering, D&N's capital-to-assets ratio increased to 6.5%, from 5%. Franklin's has grown even more dramatically, to 9.3% from 6.5%.

Neither the Securities and Exchange Commission nor investment banks track REIT-preferred issues, so it is unclear how many banks have followed Chase Manhattan's lead.

But President Clinton's 1999 federal budget plan could spur more banks to issue REIT-preferred securities. That is because the administration is asking Congress to repeal REITs' tax exemption. With a possible crackdown looming, observers expect banks to create REITs before any measure is signed into law.

REIT-preferred securities are similar to the popular trust-preferred securities; both are relatively new, tax-exempt, and can be used as Tier 1 capital.

The difference is that REIT-preferreds can only be issued by banks, not bank holding companies.

"It's a little more labor-intensive," said Michael M. Moran, a banking analyst at Roney & Co. in Detroit. "But it is an easy instrument for people to come to grips with because it is a low-cost means of raising capital."

Roney is the underwriter for Flagstar, Franklin, and D&N Financial.

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