On the surface, the case for commercial-mortgage REITs seems compelling. The credit crunch is showing signs of easing, which eventually could result in funding flowing again to commercial real estate. Also, commercial-mortgage REITs have a history of bouncing back after tough times, as they did in the aftermath of the late-1990s property bust.
Expecting history to repeat itself, investors have started to dive back into the sector. Total returns for the dozen commercial-mortgage REITs tracked by the National Association of Real Estate Investment Trusts are up almost 16% since the start of April -- compared with a 20.5% decline in the first quarter and an 11.5% decline in the fourth quarter of 2007.
"Fading liquidity concerns have led to the rally," says Bose George, an analyst at investment bank Keefe, Bruyette & Woods Inc.
Still, there are reasons to be wary. While delinquencies on commercial mortgages have remained low, there are concerns that defaults could rise if economic conditions deteriorate, putting a drag on earnings. A more immediate concern, perhaps, is whether the business model of traditional commercial-mortgage REITs -- which act like leveraged bond funds, making money only if the yields on their investments exceed the cost of their borrowings -- has been rendered obsolete by the credit squeeze.
"Their business model is essentially broken," says Jason Yablon, an analyst at REIT investors Cohen & Steers Inc. in New York.
The reason: These companies have depended heavily on the ability to sell securities stuffed with the loans they originated, called collateralized debt obligations, or CDOs, in order to lock in financing for a longer period of time to match their mortgage portfolios with long-term maturities. Today, with the CDO market all but shut, "there is no real long-term debt financing that they can rely on to fund the acquisitions of assets," Mr. Yablon says.
Say a REIT, which often counts small developers as borrowers, makes $100 million of commercial mortgages with $10 million of its own cash and $90 million in short-term bank lines. Typically, it would turn around and package those loans into CDOs and sell the securities to bond investors. The sale would enable the REIT to replace the short-term bank debt with long-term bonds. As a result, the company wouldn't have to worry about paying off bondholders before its assets matured.
Now, with both long-term and short-term financing hard to come by as banks remain wary of making loans, many commercial-mortgage REITs have no business to conduct, be it making or acquiring new loans or related debt securities.
Arbor Realty, for example, made only six new loans and investments, totaling $122 million, in the first quarter. A year earlier, it originated 28 loans and investments of $570 million.
Paul Elenio, Arbor's chief financial officer, says that "as everybody in the financial-services industry adjusts to current market conditions, we are being very selective and strategic in deploying our capital into new opportunities." If the market for CDOs doesn't return and other funding sources don't open up, he says, the business model of commercial-mortgage REITs will change accordingly.
Daniel Cohen, chief executive of RAIT Financial, doesn't think the mortgage REIT model is broken. "As the liquidity market stabilizes, I believe there will be opportunities for new investments," he says. Several mortgage REITs will give presentations at the investor forum held by the National Association of Real Estate Investment Trusts in New York this week. Investors will be eager to hear what these companies have to say about the prospects for their business.
Some commercial-mortgage REITs aren't waiting for that to happen.
Gramercy Capital Corp. recently changed to a "hybrid" REIT model, one that invests in both debt and equity. The New York firm, externally managed and 16%-owned by office REIT SL Green Realty Corp., recognized the headwinds facing the sector as far back as early last year. Gramercy, once a company that mainly invested in commercial real-estate debt, recently diversified its business by acquiring a REIT that owns properties. As a result, its business is now evenly split between owning debt and owning real estate. The transaction is "the right move at the right time," says Gramercy's chief operating officer, Bob Foley.
The logic for the move is that if the debt part of the business is stalled for a while longer, some growth can conceivably come from owning properties. And, as analyst Donald Fandetti of Citigroup notes, REITs that own properties typically carry higher valuations than those that are pure mortgage REITs.
But whether other commercial-mortgage REITs have enough time and money to transform their businesses is an open question. CBRE Realty, for instance, said in March that it had hired Goldman Sachs Group Inc. to help explore "a wide range of strategic and operational initiatives." CBRE Realty, whose recent results were hurt by bad loans tied to developer Harry Macklowe, declined to comment.
Write to Lingling Wei at lingling.wei@dowjones.com
