Dilutive Dividends: Coming to a REIT Near You!

With the capital markets offering financing in spasmodic fits of miserly insufficience, almost no capital intensive industry can escape the effects of this money mess. Few businesses are more exposed to the financial firestorm more than Mortgage REITS, which make money with old fashioned spread lending. They borrow at 5%, lend the proceeds out at 7% and pocket the difference, assuming their miscreant borrowers manage to pony up each month. But now that these REITs are unable to borrow and basically out of cash, how are they going to make it through next quarter, never mind survive?

JER Investor’s Trust (JER) offered a glimpse of the future yesterday. To my knowledge, they are the first REIT to fulfill the IRS minimum dividend requirement with stock (see “REIT Definition” for more on this) since the credit crisis began.

No, that is not a typo – JER paid their dividend with stock, not cash, and they were not wasting any time. The IRS issued Revenue Procedure 2008-68 just last week on this issue, and it provides temporary guidance to cash strapped REITs considering this cash preservation tactic (as well as an indication of the number of inquiries they have been fielding on the topic).

REITs have always had the ability to issue stock dividends in lieu of cash, but Rev. Proc. 2008-68 clarifies the amount of stock a REIT can distribute and obviates the need to seek “Private Letter” rulings from Uncle Sam. By issuing Rev. Proc 2008-68, the IRS has provided a clear safe harbor for those REITs that are considering this IOU tactic to recapitalize their balance sheets. With the new guidance, REITs now have a green light from the IRS to pay out up to 90% of their dividends in MORE stock! Yikes. You mean I have to take even more of that stuff??

There are special rules which apply to DRIP distributions of stock, and the oxymoronic requirement that investors who are short the stock presumably will now need to buy it in order to meet the dividend owed to their counterparty.

There are other cash preservation strategies available to cash strapped REITs, but with this Rev. Proc., there are none more appealing than issuing even more useless scrip. These strategies include decreasing the amount of dividend distributions (yep, next…) or deferring the timing of dividend payments. There is also the dreaded “cashless consent”, but it is of no practical use to a public REIT as it requires unanimous shareholder approval. (Shareholders must include the amount of the cashless consent “dividend” in their taxable income.)

JER’s election to pay dividends in the form of stock is currently the only viable way to raise capital. And whether they like it or not, JER is now effectively selling common stock each quarter to shareholders who are undoubtedly choking to death on what they already have.

This is also an indication of JER’s level of pessimism for 2009. Underscoring that gloom, Credit Suisse is expected to take a hatchet to its commercial mortgage staff this month Happy Holidays! leaving only a skeleton crew in New York. Those expected to be departing soon are all of its originators (loan officers), both at Credit Suisse and at their CMBS loan origination subsidiary, Column Financial. This means that Credit Suisse has basically written off CMBS as a viable business in 2009. Morgan Stanley has also made deep cuts in its real estate group.

Thus, preserving cash is really the only prudent strategy for JER, and it probably is the only practical way out of this mess for other capital-starved REITs. The net effect of the IRS guidance is that is now easier than ever for REITs to issue stock in lieu of cash, and 2009 will definitely be the year of the stock dividend. If you were counting on that cash to pay your rent, you had better look elsewhere. Click here for an updated list of REIT dividends paid in stock.