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Securitizing real estate - an update.

An Interview with Blake Eagle

The capital crunch and the continuing pressure for liquidity from real estate investors has brought real estate securitization into the forefront. Real estate has pinned its hopes on the resurgence of REITs and on the creation of instruments backed by commercial mortgages to give new financial life to the industry.

But Blake Eagle, chief real estate advisor with Tacoma's Frank Russell Companies, thinks it will take more to satisfy the demands of pension fund clients. Always an innovator, Eagle has spearheaded an effort to develop a private real estate investment exchange--a stock market for privately placed pension-owned real estate.

JPM: How did the idea of a private real estate investment exchange first develop?

Eagle: The idea for establishing a pooled real estate fund investment exchange--we call it the Clearinghouse--started about two years ago. Barbara Cambon |of Institutional Property Consultants~ and I began to compare information about the increasing backlog of pension redemption requests to liquidate positions in pooled real estate funds.

At the outset, pension funds had been told that if they wanted out of a open-ended real estate funds, they could sell their shares back to the fund. Investors in closed-end funds bought in on the basis of being fully cashed out at a predetermined date. However, since the late 1980s, fund managers have been unable to live up to these liquidity promises.

While there has been a great deal of talk about increases in equity real estate securitization, the fact is that there is already a significant amount of commercial real estate that is owned in a securitized form. It is just that in pension fund-owned pooled real estate, this "securitization" occurred in the private, rather than in the public, marketplace.

In analyzing ownership data, we observed that the large majority of pooled-fund shares are owned by the 500 largest pension plans. But we also discovered that there are over 35,000 retirement plans with assets of $1 million or more that have virtually no investment in real estate.

It occurred to us that if these thousands of plans could be introduced to the concept of buying shares in pooled real estate funds through competitive bidding, it would be possible not only to significantly expand the pension real estate investor base, but also to enhance real estate market liquidity. After all, this is what secondary markets are about.

JPM: What is an investment exchange?

Eagle: It is a central facility, or marketplace, where buyers and sellers can access good information, communicate their intentions, and transact. The more buyers and sellers, the more transactions there are. And the more transactions, the better the execution price.

Exchanges work for stocks, bonds, futures contracts, coffee, and pork bellies; so why not for securitized pools of commercial real estate?

We envision the Clearinghouse as a facility which would assume full responsibility for conducting an orderly secondary market in pension-owned pooled real estate fund shares. In this regard, the Clearinghouse would standardize portfolio-level information and organize it in a user-friendly format so that buyers and sellers could make competitive analysis studies of the data for the purpose of arriving at buy/sell decisions and pricing bids and asks. The Clearinghouse would provide the mechanism for a competitive auction market.

We envision it as a non-profit corporation that would not engage in brokering, trading, or market making. Those functions would be undertaken by others.

JPM: What was the initial reaction to your idea in the pension community?

Eagle: When Barbara Cambon and I first introduced the Clearinghouse idea to a few of the fund managers, their reactions were mixed. Some thought it was a great concept and were ready to get the project off of the launching pad. Others were, at best, lukewarm.

A third group was adamantly opposed. They prefer the real estate markets to remain private and inefficient so that they can capitalize on the market's inefficiencies.

However, as the liquidity demands in pooled funds increased and as the commercial property markets continued to deteriorate due to massive credit withdrawal and overbuilding, the idea of a pension real estate investment Clearinghouse picked up more support.

JPM: What factors besides liquidity make the Clearinghouse idea appealing to investors?

Eagle: Without any liquidity mechanisms, the pension funds may find themselves locked into their current real estate positions for many years to come. An active secondary market in pooled fund shares would give plan sponsors the option to increase or decrease their real estate exposure as they see fit.

In our view, plan sponsors want more flexibility in being able to make adjustments in their strategic real estate asset allocation schemes. Having this capability could cause more pension funds to consider investment in real estate.

Another likely benefit is the prospect of constructing more efficient real estate portfolios. As it stands now, pension funds lack any kind of tactical allocation tool to adjust allocations.

One of the dilemmas facing many fund managers is the divergence of investor interests. Some investors want to liquidate, while others are satisfied to ride out the market cycle.

For the manager to raise cash to pay off a liquidation demand, properties would likely have to be sold at substantial discounts. Thus the long-term investors would be subject to short-term losses. In addition, the same investors would incur their proportionate share of high transaction costs.

The basic concept of the Clearinghouse is to provide the appropriate mechanism to separate investor liquidity demands from today's very illiquid property markets. Let those investors that need liquidity transact at the share level where any discount is properly allocated.

The end result will be that the underlying property portfolio remains in place, and the portfolio-level risk-return profile stays the same. Investment managers are removed from having to deal with the inherent conflict of trying to serve the divergent interests of two sets of investors.

JPM: Will competing investment managers agree to share information on properties?

Eagle: A vast amount of information already exists in the pension community on pooled real estate funds. It isn't necessarily easy to access, nor do individual fund managers report in a consistent manner or on the same time schedules.

Another complaint plan sponsors have been leveling at the portfolio managers for years is the lack of information standardization. All of this makes it difficult--though not impossible--to engage in comparative analysis of individual pooled funds.

The Clearinghouse would assume the responsibility for organizing, standardizing, and updating portfolio-level data (pooled funds) on a regularly scheduled basis. The information formats would be designed to user friendly specifications that the pension funds want. Delivery would be over one or more computer-based electronic investment information networks such as Bloomberg and Telerate.

Using this type of information delivery technology, the Clearinghouse would be able to outreach to the entire universe of tax-exempt institutional investors quickly and at a low cost.

As a trading facility, the Clearinghouse would list pooled fund shares for sale. The sell offers would be immediately displayed on the screens of subscribers to electronic investment networks.

The Clearinghouse would match up buyers and sellers who agree on price. It would also facilitate the closing process by arranging for appropriate transfer documents and ensuring that individual transactions were in compliance with private market rules and regulations.

Finally, the Clearinghouse would become a store of historical pricing data by maintaining records of bids, asks, and clearing prices.

JPM: Will investment managers be willing to provide open information on properties when it may force them to mark those properties to market?

Eagle: Sooner or later investment managers are going to have to come to grips with this issue. It is interesting to observe that when stock brokers quote prices of shares of publicly traded real estate securities, inevitably they are expressed as being at a "discount" to or a "premium" above net asset value.

Implicit in this expression of prices is a recognition that commercial real estate operates in two pricing tiers. The property market prices real estate as a long-term operating asset. The securities market, on the other hand, prices shares of property companies based more on current earnings and on how real estate securities stack up to other types of liquid assets.

In the final analysis, the two-tiered markets have co-existed for many decades. The marketplace will ultimately make a determination as to whether it will be a one- or two-tiered pricing structure.

JPM: What changes will have to be made in current laws and methods of doing business to accommodate the requirements of the Clearinghouse?

Eagle: We don't as yet have all of these answers. Once the Clearinghouse is organized and is officially in business, its management will deal with regulatory compliance issues.

As we understand present-day federal securities laws, pension funds and other categories of institutional investors can trade private market-issued securities among themselves without having to incur the costs of registering the investments under the doctrine of full public disclosure. The logic of this law is based on an accepted premise that institutions are sophisticated and experienced investors and therefore fully capable of conducting their own level of due diligence.

The rules and regulations for allowing private market-issued securities to trade among institutions is spelled out in a recent Securities and Exchange Commission ruling known as SEC Rule 144A. Basically, by liberalizing the federal securities laws applying to institutions, the government hopes to enhance liquidity in the heretofore very illiquid private markets.

In this regard, the concept of the Clearinghouse falls well within the spirit of what Rule 144A is trying to accomplish.

JPM: Does that mean that the Clearinghouse will always remain private?

Eagle: Not necessarily. In the future, many pension-owned pooled real estate funds may seek to become publicly listed companies. It is entirely possible that the Clearinghouse would function as the facilitating agency to manage the conversion process.

Converting any pension-owned pooled fund from a private company to publicly owned one will require full compliance with federal tax, securities, and pension laws. In this regard it is possible some existing laws will have to be amended, new laws passed, or old laws rescinded in order to make the conversion practical, cost efficient, and in the public's interest. Nevertheless, all of this is feasible.

JPM: Why would the exchange be preferable to turning a pooled fund into a private REIT?

Eagle: To make the conversion from an existing pension-owned pooled real estate fund to a publicly traded company, the preferred vehicle is generally a REIT. For a REIT to maintain its tax preference status, it must meet several conditions, including the so-called "Five and Fewer Rule," which says that no fewer than five REIT shareholders can own more than 50 percent of a REIT's common shares. A very large number of pension-owned pooled real estate funds could not meet this test.

Another inhibiting factor is the cost of conversion of a tax-exempt group trust or separate account to a public or private REIT. Any such proposal would probably require 100 percent approval of the pooled fund investors. Trying to convince 100 percent of any investor group to go along with change is time consuming and expensive, if not nearly impossible.

Other costs that will be incurred are the charges for transferring title of each individual property asset from one entity to another. In many local jurisdictions such changes in ownership structure are viewed as a sale and therefore could be subject to local transfer taxes or sales taxes.

JPM: What degree of fund participation would be needed to create sufficient liquidity?

Eagle: At year-end 1992 we estimated that U.S. pension funds held about $110 billion of commercial real estate investments. About one half of this total is invested in more than 175 pooled funds ranging in size from $25 million in assets to $3.5 billion in assets. The total market capitalization of the pooled real estate funds is in the neighborhood of $50 billion.

Based on recent stock market data, the market capitalization of all publicly traded real estate companies is approximately $20 billion. This includes firms engaged in real estate finance and home building, as well as companies that own and operate hotels, restaurants, nursing homes, bowling alleys, and mobile home parks.

The market capitalization of the publicly traded companies that acquire, develop, and manage investment-grade commercial real estate (office, retail, industrial, and apartment) is in the $10-billion range.

Wall Street firms already have full-time real estate analysts and research departments to track and measure the investment prospects of the publicly traded real estate company sector. Many function as market makers and trade in these securities for their own accounts.

Clearly if Wall Street can make money dealing in securities of an industry sector of the public markets with a $20-billion market cap, then it is reasonable to assume that in a liberalized private securities market, similar opportunities await those who would want to participate in developing a secondary market of privately securitized pooled real estate funds that is twice the size.

JPM: How do you see the existence of a Clearinghouse affecting pension investment long term?

Eagle: If the Clearinghouse concept is accepted in the pension community, it can only encourage more pension investment in real estate. An active secondary market in these privately placed real estate securities would satisfactorily answer the two biggest concerns pension funds currently lament about real estate--lack of liquidity and lack of confidence in the appraisal process.

Investment markets flourish when there are large numbers of buyers and sellers; all have equal and easy access to information; investors have confidence in the integrity of the information; costs of information and transactions are insignificant; and best execution is easy.

Longer term, fund managers will come to appreciate the emergence of the secondary market. The pooled funds they organized and now manage will take on more and more the characteristics of permanent real estate operating companies.

Fund managers would no longer need to concern themselves with selling properties to create liquidity. As a consequence, they would avoid the no-win situation of having to serve investors with conflicting interests. Reduced liquidity concerns would also allow managers to focus all of their resources on maximizing investment returns.

In addition, an active secondary market in pooled fund shares could capture the interest of those thousands of retirement plans that at present hold no commercial real estate. If this turns out to be the case, then expanded investor participation would eventually attract more pension investment into real estate and in the process, improve liquidity and market efficiency.

JPM: Why do you think this is the right time to develop a private real estate exchange?

Eagle: There are several answers, but they all can be reduced to one common denominator--poor performance. When real estate returns began to decline precipitously in the late 1980s, there was no central marketplace where those that wanted to cut their losses and run could implement such a strategy.

In a nutshell, pension funds are now implicitly saying: if real estate is not going to produce a risk premium for illiquidity, then make the market more liquid. It is really that simple.

The idea of establishing the Clearinghouse probably would not have surfaced had the property markets stayed in relative supply/demand equilibrium with pension investors earning good investment returns. However, when any segment of the capital market underperforms, investors quickly move to sell out their positions and redeploy capital elsewhere.

It is these very troubled real estate markets that explain why the Clearinghouse concept has a large pension industry following and why eventually it could achieve success.

JPM: Does that mean that if real estate capital markets return to more of an equilibrium, there will be less demand for a real estate exchange?

Eagle: I don't think this at all. I believe the dramatic changes now taking place in the commercial property markets are structural, not cyclical.

Investors' time horizons have become shorter as the electronic delivery of information has collapsed time frames. Decisions to buy or sell are made much more frequently and involve greater numbers of asset classes.

Trading is now done for both strategic and tactical reasons as investors seek constantly to earn incremental returns and adjust portfolios to reflect changes in a more complex global economy. To be able to make trading decisions, investors demand a more liquid market.

If U.S. commercial real estate is going to play a significant role in institutional investor portfolios, then ownership in the form of more homogeneous and fungible securities is going to be more and more in demand. The Clearinghouse concept is based on this premise.

If the U.S. property markets expect to attract capital from portfolio investors such as pension funds, then they must adjust to the demands of the new capital sources.

The rules of what it will take to attract capital to the property markets are undergoing fundamental changes. As one sage pension fund veteran recently said, "I can't pay retirement benefits with appraised values."
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Title Annotation:Asset Management; interview with Frank Russell Co.'s chief real estate advisor Blake Eagle
Publication:Journal of Property Management
Article Type:Interview
Date:Mar 1, 1993
Previous Article:Appealing property taxes.
Next Article:Reining in security costs.

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