The trend toward securitization

Real Estate Weekly,  July 21, 1993  by Leonard Boxer

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The recent downturn in real estate values has effectively removed most traditional institutional lenders and investors from the real estate marketplace. This, coupled with the problems inherent to the illiquid nature of real property, has stimulated owners and lenders to seek innovative sources of capital.

Wall Street to the rescue! The investment banking community has stepped forward to create (or recreate) various products that permit owners and developers of property to bypass traditional lending sources and obtain equity and debt financing from the capital markets. These products, created pursuant to a "structured finance transaction," provide the liquidity of a security device for those who choose to invest in real estate.

The most publicized form of these transactions is the "real estate investment trust" or "REIT." A lesser publicized form is the so-called "mortgagebacked security."

In simple terms, a REIT is a corporation holding real estate, interests in real property or mortgages, which is requird to pay to its shareholders, as dividends, a significant percentage of its earnings. For income tax purposes, the corporation is accorded pass-through treatment, similar to a partnership, and is exempt from federal income tax. Various limitations apply as to the assets a REIT may own, the nature of income it may earn, and the number of shareholders it may have. Recently, several REITs have been formed using existing or newly created partnerships which hold the property and in which the REIT is a partner. These "umbrella partnership REITs", or "UPREITs". are designed to defer recognition of gain to the parties creating the entity, and to reduce various other costs.

Properties that generate steady cashflow, such as multi-family housing projects, nursing homes and shopping centers, are most suitable for REITs. Other forms of property, such as multi--tenanted office buildings and hotels, do not generate a steady enough flow of cash to provide a rate of return to make them attractive to a REIT. However, these properties are often "pooled" with others generating steady cash-flow to formulate diversified REIT portfolios.

It has recently been reported that in 1993, approximately $8 billion has or will be invested in new REITs. Generally, this investment is attributable to the above-average yields of 7 percent or more which the REITs are expected to generate. Above and beyond the yield, REITs provide the owners of their shares with the ability to buy and sell those shares in regulated marketplaces, such as the New York Stock Exchange, and the opportunity to liquidate their investment quickly and without effort.

We also have seen a recent trend in property owners finacing or refinancing their properties by creating mortgage-backed securties for sale in the capital markets, rather than relying upon the ever-illusive conventional mortgage lenders. Generally, creation of these securities involves application of very conservative underwriting practices, obtaining a "rating" from one or more of the rating agencies, and compliance with various securities laws. The new mortgage is either originated by a lender with immediate sale to a trust or originated by a trust itself. Certificates of beneficial ownership interests in the trust or debt instruments of the trust are then sold in the capital markets.

In addition to the traditional loan documents, creation of mortgage-backed securities involves other documents such as loan servicing agreements, trust indentures and disclosure documents intended to comply with the securities laws. As mentioned above, the securities are also "rated", meaning that one or more of the rating agencies has reviewed the property or properties in question, the sources of "cash flow", the legal structure of the securities, and has determined that the securities warrant a specific rating. Generally, "pools" of properties are desired for these transactions (so as to reduce the overall effect of a problem at a particular property or in a particular locality) and steady cash-flow is considered most important by the rating agencies. With respect to more speculative streams of income, use of over-collateralization techniques permit the inclusion of properties such as multi-tenanted office buildings and hotels. Recently, we have seen a number of mortgage-backed securities transactions involving single multi-tenanted office buildings where those buildings have historically been close to full occupancy, have generated a steady cash-flow, have a low debt to value ratio, and/or where one or more of the tenants of a significant portion of the building has a high credit rating.

Generally, these transactions, whether involving REITs or mortgage-backed securities, require an investment of significant time and expense on the part of the "borrower" or "issuer", and much of the expense is incurred prior to closing and whether or not the transaction is actually consummated. These transactions mandate legal and business skills covering many areas above and beyond those typically needed for traditional real estate transactions such as knowledge of underwriting practices, insolvency and securities law expertise and the structuring of sophisticated tax issues. Thus, there is a need for competent investment bankers and accountants, and multi-faceted law firms.