Just two weeks ago, I speculated about REIT capital shortages and the ability of non-traded REIT equity to fill the gap in the post Averting Massive Sector Wide REIT Defaults: Non-Traded Equity May Be Part of the Answer.

Pacific Office Properties Trust (PCE) had just disclosed their intention to raise $350 million through this market, and now NorthStar Realty Finance Corp. (NRF) is following suit with intentions to raise up to $1.1 billion in non-traded REIT equity. Whether NRF actually intends to raise this much in this market is uncertain. Offering $1.1 billion in non-traded REIT equity would be an absolutely huge undertaking, as it represents more than 10% of the market’s entire 2008 initial offering volume.

NRF remains one of my favorite Mortgage REITs, but the market has been just as unkind to NRF as it has to most other REIT stocks. The stock is down almost 70% since NRF’s chairman David Hammamoto bought a bunch of stock on the open market at $8.26/share only months ago. Management owns a significant amount of stock, so it’s no wonder they are pursuing cost-effective ways to recapitalize their balance sheet.

NRF and PCE are two of the only publicly traded Real Estate Investment Trusts to tap this market, but they are only the latest in a growing list of entities accessing this market. But do yourself a favor and don’t even think of buying a non-traded REIT. In just the first three months of the year, five companies have launched efforts to raise $7.2 billion of equity through non-traded REITs. By comparison, $9.6 billion of equity was raised in this market in all of 2008.

For Northstar, a non-traded REIT offering is an incredibly cheap source of equity capital. NRF intends to raise the equity through a new entity, so existing shareholders in NRF common will not be diluted. The new NRF non-traded REIT intends to pay its investors an annual REIT dividend of 8 percent, which would be higher than the 5-7 percent typically paid by non-traded REITs and far better terms on equity than what NRF could get elsewhere.

While the offering is undoubtedly very attractive to NRF with respect to the scant alternatives available, it remains to be seen how well shareholders in the new entity will fare. Investors will pay fees of as much as 7 percent to cover the cost of selling commissions; a 3 percent dealer-manager fee, and 3 percent to cover the costs of organizing the entity. Accordingly, only 87 percent of every dollar raised will actually go toward investing in mortgages.

NorthStar’s aim is to execute what it termed a “liquidity transaction” within five years of raising the capital. That could be a sale of assets, merger or listing on a stock exchange. Historical non-traded REIT returns are hard to quantify, because so few have executed their so-called liquidity events. Given how cheap this capital is, it’s no wonder.

Disclosures: Long NRF at the time of publication
mortgage reits
office reits,
reit,

REIT stocks are in all sorts of unprecedented trouble. They depend on leverage, and to the extent that it can be had at all, it’s become more expensive and tougher on terms. Consequently, the weighted average cost of capital (debt and equity combined) for REITs will increase by an average by 100-200 basis points, to 7-8% all-in, according to Goldman Sachs. With the cost of capital going up, cap rates must also increase and consequently commercial real estate values will inevitably drop further. This creates a kind of negative feedback loop that even Harry Houdini could not escape.

This will inevitably affect the ability of REITs to refinance their own debt. Indeed, the reduced ability reduced availability of capital has already impacted the clients of many Mortgage REITs. These borrowers have historically sold assets or refinanced their loans via the secured debt markets to repay Mortgage REIT loans. They can no longer do so, and Mortgage REITs like iStar financial (downgraded deep into junk status by Moody’s yesterday; almost 30% of SFI’s portfolio is non-performing) have seen their balance sheets turn to cement. If this environment persists, there could be a massive wave of defaults on REIT-related debt.

While Goldman Sachs’s REIT research team recently issued a report that was cautiously optimistic on a few names, they also noted that commercial real estate is eroding at a pace indicating that occupancy and rental declines should match the deep recession of the early 1990s. Read Goldman’s full report on REITs here

With the availability of credit vastly reduced and commercial real estate values likely to drop by 30-40%, REITs will need to contribute a considerable amount of equity in order to successfully refinance approximately $20-$30 billion of debt coming due in 2010. The problem is compounded by the fact that “asset sales are not currently a viable option, given the lack of funding alternatives available to buyers and the uncertainty over pricing (rising cap rates and falling NOI levels)”

So REITs must conserve what little capital they have by paying dividends in stock, and by attempting to raise capital in whatever markets may be open to them. According to Robert A. Stanger & Co., one of those markets may be the “non-traded” equity market, which raised over $9.5 billion in REIT equity during 2008, including over $2 billion during the fourth quarter alone.

Much like a preferred issue, non-traded REIT equity is issued to a stable group of retail investors and offers a predictable yield, paid monthly, and none of the gut wrenching daily price gyrations seen in the common. Whether this market is deep enough to absorb the daunting capital requirements of many capital-starved REITs remains to be seen, but an increasing number of such REITs will undoubtedly be taking a hard look at non-traded equity in 2009.

One of the first out of the gates was Pacific Office Properties Trust (PCE). PCE is an Office REIT, and they disclosed goals to raise $350,000,000 in a February 6th registration with the SEC. Pacific Office hopes to tap into a stable capital source that, because of its modest yield (7%), will be accretive to the holders of its listed common shares. Interestingly, because PCE’s non-traded equity is a so-called “Covered Security”, it will not be subject to expensive and arduous “blue-sky” registration in many states. This represents a significant advantage over a typical non-traded publicly offered REIT.

Despite its ambitious fundraising goal, at the time of the filing PCE had not even identified a broker to sell the shares. However, the PCE offering could be the first of many such deals for undercapitalized REITs reluctant to offer dilutive follow-on offerings of common at current prices.

Non traded REITS are actually a horrible investment (read Non-Traded REITs are Designed to be Sold not Bought. They have been criticized by many analysts because, among other reasons, they are sold through brokers who charge higher commissions than would be paid buying public REITS. This depresses the total return for the investors who buy the shares.

Non traded REITs are also less liquid. Most non-traded REITs will only buy shares back after an investor has held them for at least a year. Many typically also reserve the right to suspend redemptions if investors try to sell back more than 5% of all shares in a 12-month period. Last fall, Inland Western Retail Real Estate Trust Inc., suspended its program to buy back shares after the same 5% limit was reached. These investors are out of luck in terms of liquidity.

Nevertheless, offering non-traded REIT shares may help solve some public REIT balance sheet issues as well as address looming 2010 debt rollovers. These rollovers will require more equity in order to be successful, and without that the REIT world will almost certainly get even uglier for shareholders and lenders.

Disclosures: None at the time of publication
mortage reits
reit stocks
apartment reits, reit,