Wall St. and real estate: an odd marriage.

There was a time when it was unthinkable that Wall Street and real estate, two distinctly disparate industries, could be compatible in any way. Like oil and water, they seem not to mix, because they represent two different mindsets, two different disciplines. Real estate is a long-term business, whereas the security industry has a minute by minute mentality. Wall Street regards real estate properties as fixed assets, not liquid, and unlike stocks, bonds, or securities which can be sold at the end of a working day, buildings and land cannot.

However, in order to create new financing products, Wall Street investment bankers devised a way to securitize real estate assets. Securitization, experimental at first, is now a method commonly opted for by large institutional investors for real estate investing. In addition, equity REITs, publicly traded real estate equities, based on the same principle as securitization, have become an extremely popular investment vehicle for real estate. It's helpful to understand the historical factors which led to the creation of securitization, this odd marriage of Wall Street and real estate.

Commercial real estate lending in the 60s was far less sophisticated than it is today. The hard core lenders of yesteryear were savings banks, insurance companies, pension funds, and commercial banks. Each institutional lender had its own market; business was straightforward and defined. Usuary restrictions, regulated by each state, specified how much interest could be charged.

Then came the oil crisis of the early 70s, bringing with it the first wave of inflation. For the first time, world markets had an impact on domestic financial markets, resulting in huge rate rises, which reached a pinnacle in the early 80s when the prime rate soared to 21 percent. Permanent mortgage rates climbed well into double digits, resulting in the demise of a number of savings banks, which had been borrowing on a short-term basis.

Believing that interest rates were so high they would eventually fall, savings banks continued to make loans, while long-term rates continued to rise. While earning only single-digit returns on their existing portfolios, these institutions offered to make loans at these historically high rates, but failed to attract borrowers. The thrifts lost vast amounts of money. The guillotine fell, banks failed, went out of business, or fell under the umbrella of the FDIC; mergers took place, ensuring the survival of only the fittest.

In the meantime, insurance companies sold their clients policies containing built-in loan provisions so that they could borrow at extremely low rates, (4 to 5 percent). Cash surrenderers borrowed at these low rates and invested in Treasury bills at 7 to 8 percent. This came to be known as disintermediation. The situation had dire implications. This vas outflow of institutional dollars, coupled with high inflation, meant that financing for real estate deals simply dried up. The crippling credit crunch hit hardest in the Northeast, already suffering from the oil crisis. The Southwest, particularly Texas, fared better only because they were producers of oil.

Mercifully, there was still sufficient equity money around and there were still tax shelter deals to be made. But the thinking of those who did tax deals was skewed. They didn't really care that properties made money because they figured (wrongly) that at some point in time the value of their real estate would go up. Believing that double-digit inflation was here to stay, new banks and new savings and loans emerged nationwide, but generally their management was overzealous, incompetent and, in a number of cases, corrupt. Most lenders were doing deals to build up the value of the banks and to get fees. They did not take enough care to value the properties they were lending on. The thrifts made construction loans of up to 85 percent of the cost, investors provided the other 15 percent which was tax sheltered, the developer got his fees, and all seemed fine.

However, the tax benefits made investing in real estate too lucrative. The Tax Reform Bill of 1986 changed the whole scenario. Some properties lost approximately 30 percent of their value overnight; many investors were wiped out; many declared bankruptcy. The upside was that the Tax Reform Bill weeded out those investors who invested in real estate solely to enjoy tax benefits. The downside was that the real estate industry went into a serious decline.

"Necessity is not only the mother of invention, but the father of success." Investment bankers took a close look at the financial components of fixed assets and invented a way to successfully pool them into securities. A huge critical mass of properties was required at first, to make these pools profitable, somewhere in the region of an aggregate value of $100-200 million. Since few institutional lenders during those years could put up that kind of money for a real estate deal, securitization seemed a viable alternative.

The next step in the process was to refine this blueprint for securitized financings so that smaller loans of $1-12 million could be pooled and traded in the markets. Thus Wall Street firms started to originate small loans, to amass pools of properties, get them rated, and sell them as securities, giving rise to a whole new industry. Mortgage bankers jumped on the bandwagon by originating loans for the investment bankers. And these pools of properties were divided up into tranches or tiers and rated from "A" downwards. Therefore, the more financially viable loans, those with lower loan-to-value ratios, could be traded at a better rate.

The creation of securitization gave a jump start to the complex task of real estate financing during the credit crunch years. Institutional investors and entrepreneurs alike found a way to invest in real estate and still enjoy the liquidity that conventional securities offer. Moreover, securitized financings of real estate properties offer institutional investors a far less risky investment than a conventional loan on a property. There's a built-in exit strategy and there's a way to measure performance. Although one or two loans in the pool might decline, others might thrive, balancing out the overall performance of the group.

What's interesting is that buying a portion or piece of a security in a pool of loans is much more attractive to institutional investors than committing to make the whole loan. Lenders prefer the liquidity that securitized financings offer, even if the returns on an "A" piece of the security are less than the returns on the entire property. Having been burned by bad loans in the past, liquidity is critical to institutional lenders who cannot afford to be stuck owning real estate assets they can't sell.

In my view, as long as interest rates are affordable, securitized financings are here to stay. Investors are equitizing their positions by taking their deals to Wall Street and although no one could ever have forecast a marriage between the differing mindsets of long- and short-term investors, history has led us to pioneer an exciting new frontier which makes real estate, once again, an attractive and profitable investment.