IPOs Take Aim at Distressed Deals

With every downturn comes the opportunity to gain market share. And the investor class poised to do so in the near-term is real estate investment trusts. Though equity REITs were hit hard as the economy started to head south, some have been able to raise substantial capital this year. But right now, all eyes are on the new spate of 12 proposed mortgage REITs, most of which were launched to specifically target distressed assets.

Take Starwood Property Trust Inc., for example. The Greenwich, CT-based company wrote in its prospectus, "We believe that there will be a significant supply of distressed investment opportunities."

Starwood Property continued, "We expect to capitalize on these market dislocations and capital void by acquiring real estate debt positions, and originating new loans and other real estate related debt investments," The firm raised a total of $951.5 million since August.

Three other companies planned IPOs in late September with a similar goal:

Foursquare Capital Corp., targeting $500 million, Colony Financial Inc., seeking $250 million, down from an initial $500 million, and Ladder Capital Realty Finance, pursuing about $400 million at press time.

What's more, four more REIT IPOs are in the pipeline: Petra Real Estate Opportunity Trust, targeting $200 million, Transwestern Realty Finance, aiming for $500 million, AG Financial Investment Trust, eyeing $300 million, and Bayview Mortgage Capital, seeking $500 million. All told, this new crop of distressed-asset REITs, including the ones already launched, could raise about $3.6 billion.

"The more these guys come in and start investing, the more they'll prop up asset prices,"says Nick Einhorn, an analyst with Renaissance Capital. "From a macro perspective, it's probably a good thing for the market and a good sign that people are willing to buy now. A lot of commercial debt is rolling over in the next five years-about $1.4 trillion. And a lot has to be refinanced, and you need capital to do that."

There's been talk that the new crop of mortgage REITs aims to fill the void left by some of the traditional lenders, which tightened their standards to the point of barely lending, consolidated or dissolved, it la Lehman Brothers.

"It's positive for the marketplace and very much needed," says Steve Pumper, executive managing director of Transwestern in Houston. "There's not enough capital for the debt side of the marketplace. The number of capital providers dropped precipitously."

There were also rumblings around the industry that some of these players may look to get in the door as lenders and eventually become real estate owners as properties foreclose and keys are returned. While that remains to be seen, Starwood and other proposed REITs declared in their prospectuses that they are not targeting "loan-to own investments," And as Einhorn explains, foreclosure is an expensive process, and it's unclear whether it would be worthwhile for investors to get real estate that way.

Einhorn adds that the surge in REIT IPOs is not necessarily a permanent shift in the marketplace. "People will be looking to see if these vehicles will do well. But I think this is a play based on the environment we're in right now. It's hard to deduce any long-term moves."

People have identified this period as one of those transition markets where there'll be a lot of opportunities, says Thomas A. Fink, senior vice president and managing director of Trepp. "People are trying to amass as much capital as possible to take advantage of those opportunities," he says.

What makes REITs so attractive right now is that they have more money in liquid investments and therefore have the ability to move more quickly on deals. "REITs can raise money on the equity side and are successful with favorable rates raising unsecured debt. They're more flexible," said Patrick Sargent, president of the Commercial Mortgage Securities Association, speaking at the RealShare Distressed Assets conference in Dallas last month.

A number of the new mortgage REITs are targeting double-digit ROEs with wide margins of safety another attractive selling point, Einhorn says. REITs can basically buy mortgages and securitized instruments at steep discounts and achieve double-digit returns. Even if more loans than expected turn out to be non-performing, the high yields on the performing mortgages can provide a substantial cushion, according to a September report by Renaissance Capital, "Mortgage REIT IPOs: Real Estate Dislocation Offers Opportunities."

REITs can also take advantage of "historically low, short-term borrowing rates and government financing under the TALF and PPIP programs by levering their portfolios and magnifying their strategies," the report said.

With so many REITs coming out in such a short window, management pedigree and REIT structure have become a real differentiator, Einhorn says. Starwood touted its "proven debt investment track record in distressed market conditions similar to the current market" in its prospectus. In fact, in the early '90s, Starwood Capital Group's first fund invested primarily in distressed assets sold by the Resolution Trust Corp. Two of its early funds also capitalized on distressed debt opportunities.

Colony Financial plans to benefit from its affiliate's similar experience buying distressed assets from the RTC. New REITs with less noteworthy credentials may have a tougher time attracting investors, as evidenced by smaller offerings.

And some downsizings, like Colony's, may just be a factor of arriving too late to the party. "There comes a point when investors are satiated," Einhorn says.

Still, many in the industry expect REITs to become bigger and stronger during this downturn. "No question, REITs have an opportunity to own quality assets across the country in all asset classes,"Pumper says.

Speaking at the conference, Robert Knakal, chairman of Massey Knakal Realty Services in New York City, said, "REITs will be dominant, they have access to public capital and will be a dominant player going forward," As we head into the fourth quarter and into next year, more of these vehicles are expected to price and those already out will start to look to deploy capital. But, there are plenty of challenges facing both equity and mortgage REITs in this market. "Right now equity REITs have an issue finding reasonable financing because they don't want to pay 100% cash,"Trepps Fink says. "A number of REITs have increased capital within the confines of their structure, but finding a third-party to lend money may be difficult. Mortgage REITs are trying to identify reasonable projects to lend. A lot of the properties that need capital need more than they are willing to lend. And there's still a disconnect between what property owners and lenders think is a viable loan."

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