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Washington, DC-based Friedman Billings Ramsey has garnered an impressive track record in its 16-year history. Included in the wins of this investment bank with its $2-billion market cap are its participation as co-underwriter in Resource Capital’s $287-million IPO and the 1998 launch of Capital Automotive REIT. The common thread between the two deals–and a kingpin of FBR’s strategy–is the client firms’ non-prime real estate holdings and FBR’s penchant for spinning those assets into separate balance sheets. But times, they are a changing, and in a recent, exclusive interview, FBR senior managing director F. Fuller O’Connor Jr. tells GlobeSt.com that while the opportunities in alternative plays are great and growing, REIT status for these balance sheets is on the wane. Why this is and what will replace REITs all figure in FBR’s strategy for 2006 and beyond.

GlobeSt.com: Why the focus on alternative real estate holdings?

O’Conner: There are many real estate-intensive businesses that could finance more efficiently if they separated their real estate from their operations. Because of that, we’ve created a number of companies that own various specialized types of real estate that would be unique from other existing REITs.

GlobeSt.com: Can you give us some examples?

O’Conner: It includes companies that focus on agricultural products such as vineyards; it includes heavy manufacturing, power plants, cell phone towers, hospitals. There are a wide variety of businesses on which we can base new real estate companies. The basic idea is that most real estate companies have focused on the four major food groups. Now we’re seeing many more opportunities to look at specialized property types. There have been some done in the past–prison REITs and golf REITs. Companies can create a higher return on equity by separating out their real estate and putting that additional capital back into their operations.

GlobeSt.com: Can you talk about the growth potential?

O’Conner: I can’t give you a number, but there’s the potential for a substantial amount of growth.

GlobeSt.com: You’ve had this model for a long time, but I assume that now it’s being fueled largely by the huge amount of capital flooding into the primary asset types.

O’Conner: That’s exactly right. We’ve seen yields being compressed on all of the core property types as cap rates have fallen. So we’re in search of property types outside of the mainstream where higher yields can still be achieved.

GlobeSt.com: But where does that leave the four main groups in your strategy?

O’Conner: We’re very bullish on hotels. The supply/demand dynamic is very positive. Office is more challenging, but it’s still exciting. There are a lot of passive owners in the sector that don’t do a very good job managing their properties, so we’re looking at some transactions with local sharpshooters who think they can do a better job managing properties than passive, absentee owners can.

GlobeSt.com: And what about retail, industrial and multifamily?

O’Conner: Industrial is a small sector and we haven’t spent a lot of time focused on it. It tends to move with the economy, so it is picking up. Retail has performed quite well and we think there are opportunities there. In multifamily, the stocks are ahead of themselves. Everyone assumes that with interest rates going up housing demand will slow and apartment demand will grow, but that already seems to be priced into the stocks.

GlobeSt.com: This website has reported the growing theory about cap-rate contributions going away. Do you buy into that?

O’Conner: I do. We look either at companies that can lock in attractive spread investments or at companies that can grow that income at the property level. We never make a bet that a company can increase valuation with declining cap rates. So I think generically, the day of the cap rate is over. You might find it here or there, but you need to either lock in spreads or grow NOI.

GlobeSt.com: You believe also that the day or the REIT is giving way to the day of the C-Corp. Why?

O’Conner: The future for property companies is more exciting in a C-Corp. format for a variety of reasons. The primary reason is that you’re not living with REIT rules. It isn’t punitive economically to be a C-Corp. because depreciation shields most of your taxable income. Also, a C-Corp. can leverage to more normalized levels, similar to where CMBS loans leverage, approximately 75%. If you leverage 75%, it gives you enough of an interest deduction when combined with your depreciation deduction that you basically don’t pay taxes. And if you don’t pay taxes there’s no reason for you to be a REIT. That’s why we’re optimistic that companies that wouldn’t live with REIT rules and wouldn’t go public now can go public.

GlobeSt.com: Do you see it as advantageous to firms that would be REITS or for trusts interested in conversion?

O’Conner: REITs in place for a long time will be slower to change. Newer companies coming public will increasingly look at it seriously. The REITs that would convert are the more opportunistic REITs that want to be more actively engaged in buying and selling property as opposed to being a long-term investor.

GlobeSt.com: Why now?

O’Conner: There are a couple of reasons. It’s an evolution. When REITs became popular in the mid ’90s, we were coming out of a deep real estate recession. Analysts and investors wanted to see REITs be very lowly leveraged, which means you don’t have enough interest deduction to shield your taxes. Over time, especially as the debt markets have become more sophisticated and more liquid, the market has become more comfortable with companies leveraging higher–not outside the norm, just higher. The CMBS market is very comfortable with 65% to 75% leverage, and the ratings agencies are comfortable at the level. All the delinquency data shows that that is not a risky level of leverage and the equity markets are moving toward accepting that. One reason they’d be willing to accept that is that in a C-Corp. you don’t have to pay out all of your cash flow. Every day you receive a rent check you de-leverage, which is not the case with a REIT. A C-Corp. becomes a self-financing vehicle.

GlobeSt.com: You’re structured as a REIT. Plans to change?

O’Conner: No.

GlobeSt.com: Not good for the gander?

O’Conner: We don’t own property. We deal in mortgage investments so there are no depreciation expenses. REITs are the best format.

GlobeSt.com: You spoke about safe levels of leveraging. Are there concerns about what they mean in terms of future performance?

O’Conner: We haven’t seen those concerns. What we can learn from the CMBS market is that 65% or 75% leverage levels aren’t risky. You’ll see maybe one-tenth the delinquencies and defaults you’d have in triple-B corporate bonds. It’s proven that real estate is an asset class you can safely leverage to these levels, and the equity markets are warming up to it.

GlobeSt.com: Is real estate becoming a cycle-free endeavor?

O’Conner: Everything is cyclical. The peaks and valleys will be smoothed out from what they once were because capital is smarter and the public markets have instilled a discipline both on the debt and equity side. The securitization of both mortgages and ownership means that properties are better capitalized and that underwriting criteria is more standardized. We don’t see supply and demand swinging out of balance as they had in the past.

GlobeSt.com: So what worries you?

O’Conner: If the Fed raises rates too far and the economy slows dramatically, that would have a negative effect. Sometimes the Fed has gone too far and hopefully they’ll avoid that.

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