Real estate financing trends.

Real estate finance is in a period of construction, change, and creativity. Banks, insurance companies, savings and loans and foreign investors are reducing their new commitments, focusing instead on resolving troubled assets and borrower refinancing. REITs, credit companies, pension funds, and select foreign investors have retained their interest, finding new and profitable ways to stay in the market. This article explores trends with sources still active in the market.

Real Estate Investment Trusts

Amidst the current environment of depressed real estate, the Real Estate Investment Trust is one bright spot in the marketplace. For owners, operators and developers, REITs provide an investment vehicle to raise necessary capital. For investors, REITs provide a securitized investment that is an attractive alternative during a period of low interest rates.

While 1991 was a good year for the REIT industry, 1992 was a stellar year. At the time this article went to press, the final 1992 statistics had not yet been compiled. However, the National Association of Real Estate Investment Trusts reports the following preliminary statistics:

* REIT assets increased by $2.8 billion to $48.8 billion at the end of 1992.

* Thirty-five REIT offerings were completed in 1991 which raised a total of $2.3 billion. In 1992, the number of REIT offerings grew to fifty-eight, which raised nearly $6.6 billion.

* The average dividend yield paid by REITs was 7.88% for 1992. Because the yield was lower than for 1991, REIT stocks appreciated in value and the pricing of new REIT offerings was more attractive in 1992.

* Assuming reinvestment of dividends, the total return on investment of REIT's surpassed 35%.

REIT's popularity is driven by recent success in the markets and their ability to fill the void left by banks, S&L's, insurance companies and syndicators. A REIT is essentially a mutual fund which invests in real estate. While there are a number of constraints on REIT operations, there are many advantages to the REIT structure.

* From a tax perspective, a REIT is a corporation which receives a deduction for the dividends it pays to its investors. Income is passed through to investors, free of tax, at the corporate level. Unlike partnerships, REITs cannot pass losses through to investors. Investor tax reporting is simplified because investors receive a Form 1099 instead of a complicated Schedule K-1.

* REITs are usually organized as corporations and have a similar capital structure. As with other corporations, REITs can issue common and preferred stock, as well as a wide variety of debt instruments.

* REITs are a liquid investment. Unlike partnerships, the tax laws require that REIT shares be transferable. Most REITs are publicly held and, thus, there is an established market for their shares.

* Tax exempt investors, including pension funds, enjoy certain tax advantages by using the REIT vehicle.

* For a variety of reasons, the REIT vehicle is attractive to foreign investors. European and Asian real estate investment has historically been conducted using publicly traded vehicles.

REITs must meet a variety of operational and organizational tests in order to qualify for favored tax treatment. REITs must distribute at least 95% of taxable income, income must be derived principally from real estate investments, and investments must be in real estate or mortgages which are secured by real estate. REITs are constrained from operating a trade or business, such as a hotel or racetrack. Furthermore, REITs are prohibited from acquiring or developing property for resale.

Many real estate operators have chosen to convert their operations and to become public REITs. In the 1980s, several public trade partnerships, including Burnham Pacific and the Angeles Mortgage partnerships, converted to REITs. More recently, Public Storage has converted several of its partnerships to REITs. In late 1991, Kimco Realty Corporation, which operates 126 neighborhood and regional shopping centers, reorganized its capital structure as a REIT and raised $128 million in an equity offering. All of these have become fully-integrated companies that manage their own properties.

In August 1992, Taubman Centers, Inc. filed registration documents with the Securities and Exchange Commission in one of the largest and most sophisticated REIT offerings to date. The offering was successfully completed in November, raising approximately $300 million. The Taubman offering is unique because the REIT will become a partner in a holding partnership which will own all of Taubman's real estate interests. The existing partners will receive "put" rights, enabling them to exit the partnership by selling their partnership interests to the REIT.

This structure, which Wall Street now refers to as the "Umbrella Partnership REIT", defers the tax liability associated with the more traditional REIT formation structures. Last week, a second Umbrella Partnership REIT, Carr Realty Corporation, completed a successful offering demonstrating Wall Street's acceptance of this new structure.

By converting to REITs, many real estate operators have gained access to capital markets that they otherwise would not have enjoyed. They also have provided liquidity to investors. In the case of partners who own illiquid partnership interests, the REIT public marketplace can be a tax-efficient means of providing liquidity for estate planning purposes.

The REIT is an attractive vehicle for long term investment in real estate. Although certain operating constraints are imposed by the Internal Revenue Code, once these are overcome, the REIT is an excellent vehicle to securitize real estate equity and debt investments.

Credit Companies

Credit companies, typically Japanese or American corporate loan subsidiaries, have increased their market share of real estate financing due to the withdrawal of more traditional sources. By some estimates, they are responsible for generating as much as 20% of the total volume of new funds in the marketplace. However, by any count, credit companies have become and will continue to be an important source of real estate financing due to their ready access to money through the selling and guaranteeing of commercial paper.

Despite the increase in the market share of credit companies, the number of credit companies operating in the real estate financing arena has dropped dramatically since the late 1980s. Less than ten major credit companies are currently active in the real estate financing market. Furthermore, whereas credit companies used to be the "lenders of last resort" due to their high cost and penchant for more risky deals, credit companies now are able to achieve attractive returns through conservative main line lending with more risky deals done on a more selective basis.

Credit companies originate permanent loans, residential acquisition and redevelopment loans, construction loans, second mortgages and even fund stand-by commitments. Credit companies have also become active in commercial mortgage securitization, buying large portions of deeply discounted commercial loans and then re-syndicating the loans to other lending institutions or retaining the portfolios for themselves.

Pension Funds

Pension funds continue to invest strongly in real estate. While historically focused on large office and retail properties, pension funds have begun investment in apartments, smaller commercial properties, and even single-family construction.

CalPERS allocation of approximately $400 million to California single-family construction in early 1992 represented a significant departure for pension funds and bodes well for a growing infusion of new institutional capital into Southern California's beleaguered housing industry.