As private-equity firms struggle to find investments amidst a bleak deal environment, many are looking beyond traditional leveraged buyouts.
Some, like Angelo Gordon & Co., Apollo Management LP, Blackstone Group, Colony Capital and Starwood Capital Group, have taken an even more daring leap, launching IPO market gambles to reap potentially lucrative returns from the purchase of commercial and residential mortgage-backed securities and real estate loans.
Along with a handful of asset management firms, a bevy of financial sponsors have formed real estate investment trusts over the last few months to tackle a $680 billion mountain of outstanding CMBS with $205 billion coming due by the end of 2012, according to New York commercial mortgage data provider Trepp LLC. Overall, the supply of mortgage debt held by banks, insurance firms and specialty mortgage companies in the U.S. totals roughly $3.2 trillion.Several investment firms registered initial public offerings with the Securities and Exchange Commission under the REIT structure in July. The idea hinges on using IPO proceeds and government-backed debt to finance investments across a broad spectrum of commercial and residential mortgage-backed securities and loans because, as Starwood's REIT prospectus notes, "The next five years will be one of the most attractive real estate investment periods in the past 50 years."
If the recent performance of REIT indices offers any indication, the financial sponsor crowd could well be jumping into the market at the right time. In July, the FTSE NAREIT All REIT index increased 10.2%, and surged 65.5% from March 6, when REIT share performance bottomed out, through the end of July.
Morgan Stanley expressed confidence in the industry's market surge yesterday in a report, noting REIT stocks had an "explosive 34% rally" since early July. Additionally, the investment bank said it was raising its 2010 valuation targets for REITs by roughly 15% "on the basis of moderating sector headwinds" as investors shifted their focus from liquidity concerns among the investment trusts to acquisition-driven growth.
Even some non-mortgage REITs have moved to invest in the legacy debt opportunity.
HCP Inc., a health care REIT, announced on Monday that it had acquired a $720 million chunk of mortgage debt held by JPMorgan for HCR ManorCare, a portfolio company of Washington private-equity firm Carlyle Group.
The Long Beach, Calif.-based investment trust, however, only paid $165 million in cash for the discounted $590 million purchase and used financing to fund the remainder, which it expects to generate a 13% rate of return.
The debt stemmed from $3 billion in mortgage financing that came with Carlyle's $6.3 billion acquisition of the Toledo, Ohio-based nursing home operator in December 2007.
"REITs that have the approval in their governing documents to invest in mortgages are doing just that. It appears that the big banks will begin to start dealing as they can clean up their balance sheets," says Philip Feder, chairman of the global real estate practice at Paul Hastings.
The new mortgage trusts are seeking to use financing from the government's TALF and PPIP programs to support their purchases of CMBS and related debt as some IPO filings have indicated. Uncertainty and valuation issues, however, continue to hang over the mortgage debt market like dark clouds.
"The question is, where will the market level off and how will you value these assets?" says Tom Butler, a transaction services partner at PricewaterhouseCoopers.
The latest round of IPO registrations aren't the first by financial sponsors keen on investing in mortgage debt. The Cypress Group, a New York buyout group, and Waltham, Mass.-based fixed-income firm Sharpridge Capital Management LP registered Cypress Sharpridge Investments Inc. two years ago to go public; they succeeded in raising $100 million in June.
Separately, American Capital Strategies Ltd. of Bethesda, Md., priced its IPO of the RMBS-focused American Capital Agency Corp. at $200 million in May 2008 after its initial registration in February 2008.
The tax benefit in using the REIT structure is clear. If 90% of its income is distributed to shareholders through dividends, the investment trust doesn't need to pay corporate taxes.
But private-equity groups are reaping more than just tax benefits from the structure.
By launching a REIT, financial sponsors can bypass trying to raise private capital from endowments, insurance companies and pension funds, a tough prospect since many institutions are focused on portfolio allocation issues rather than making commitments to new alternative investment partnerships.
Additionally, the new REIT launches are taking advantage of market dynamics like declining commercial property values, falling occupancy rates and flat rental increases.
Brad Case, vice president of research and industry information at the National Association of Real Estate Investment Trusts, says the newfound investor interest is akin to the early 1990s when a series of REITs were formed through IPOs to invest in attractively priced assets. "They've recently come back into vogue and what we're seeing right now is what we saw 18 years ago in 1991. We've come to a situation where assets in the private market are still weakening, but investors are excited about publicly traded REITs to take advantage of those opportunities."
One reason investors are keen on the REITs, he says, is the transparent nature of the public vehicles.
Some Skeptics
Not everyone is convinced the REITs, however, will tickle the fancy of IPO investors.
"While there is a consensus that this should be a fantastic investing opportunity, there's a question of how quickly these [REIT] companies can amass portfolios," says Steven Marks, head of the REIT group at Fitch Ratings.
Fitch issued a negative outlook on the U.S. equity REIT sector on Wednesday and raised the prospect of further downgrades, primarily because of weak real estate market fundamentals, increasing capital costs, stricter debt covenants, high unemployment rates and the economic downturn.
Deteriorating market conditions and high leverage have also taken their toll on REITs like Chicago-based General Growth Properties Inc., which filed for bankruptcy in April.
A host of REITs have been able to reduce their debt through follow-on equity offerings, which totaled $12.8 billion since March, and $2.8 billion in debt placements. One REIT that secured $710 million in new financing, Vornado Realty Trust, is reportedly interested in raising a $1 billion private-equity fund to buy distressed properties even as it posted a $122.7 million loan loss for the second quarter on Tuesday.
A Vornado representative declined to comment on the fundraising.
It is not just valuation issues that pose a challenge for prospective mortgage debt investors, says Jim LeBaron, a senior director at Southfield, Mich.-based business consultancy BBK. "You've got a number of performance issues as to whether these loans can be restructured and get them to where they'll perform."
LeBaron believes the IPO proposition for public market investors might not be as attractive as it may initially seem. "I think there's going to be a reluctance to offer up these securities at a severe discount," he says.
Take the lackluster response to the IPO of PennyMac Mortgage Investment Trust last week, an offering that doesn't exactly bode well for upcoming REIT issuances. A Calabasas, Calif.-based REIT backed by BlackRock Inc. and Highfields Capital Investments LLC and managed by former Countrywide Financial President Stanford Kurland, PennyMac raised $320 million, or less than half of its original goal to secure $750 million for buying residential mortgage loans when it filed its registration statement in May.
Merrill Lynch, Credit Suisse and Deutsche Bank underwrote the offering, which illustrates the potential resistance the new issuers face in an already shaky public offering market.
The premise behind the latest mortgage REIT wave parallels, in some ways, another investment vehicle that didn't quite live up to snuff: the special purpose acquisition company.
Like SPACs, the new mortgage REITs are essentially blind pools and like the acquisition vehicles many are sponsored by high-profile investors.
Some acquisition companies have been able to capitalize on REIT interest in legacy debt. Former Carlyle Group dealmaker Mark Ein, chief executive of Capitol Acquisition Corp., tapped into the opportunity in June after the SPAC raised $258.9 million in an IPO last November. In June, Capitol announced that it was being acquired by newly formed REIT Two Harbors Investment Corp. through a deal whereby Minnetonka, Minn.-based investment firm Pine River Capital Management LP will manage the mortgage trust's investment activities.
The deal wasn't the only new mortgage REIT born out of a SPAC merger.
Enterprise Acquisition Corp. and Armour Residential REIT Inc. announced their $250 million merger on July 29 whereby Enterprise will be subsumed within Armour, a company overseen by former Bimini Capital Management Inc. REIT CEO Jeffrey Zimmer, who is serving as co-CEO of Armour alongside Scott Ulm, formerly CEO of structured finance company Litchfield Capital Holdings. It will invest in adjustable-rate residential mortgage-backed securities.
"This deal is creating a platform that doesn't work unless you have a management team with deep industry experience that can generate appropriate returns for investors," says Michael Tew, a co-founder of SPAC Research, adding "investors have been very receptive to REIT issuance in the current environment with the tremendous amount of distressed opportunities."
Tew, who tracks the IPO and acquisition company market, says the equity REIT sector ranked third in terms of overall equity issuance in the first half of the year.
Bradley Real Estate Investors, First Mortgage Investors and Continental Mortgage Investors were some of the earliest U.S. REITs. Continental was the first to go public with its listing on the NYSE in 1965, according to NAREIT.
— Kelly Holman is assistant managing editor of Investment Dealers Digest.
