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Bob Tonachio

Stocks of many real estate investment trusts (REITs), which were popular among income-seeking, retail investors, are still trading at high price levels that only reflect an ordinary recession in commercial real estate. REITs were designed to invest in portfolios of rental properties, and generally pay no corporate income taxes if they distribute at least 90 percent of their profits as dividends to their shareholders. REITs were designed to flourish in an environment of rising property values and rents. But in this commercial real estate debacle, the REIT business model has ceased to function as designed; a REIT’s tax-free status doesn’t allow it to retain sufficient capital to survive during lean times. Since REITs pay out 90 percent of their earnings, they must take on more and more debt to grow. During the up cycle, an aggressive REIT strategy of growth, leverage, and acquisitions was a virtuous cycle that led to hefty dividends and vertiginous stocks; come the bust, it’s produced a vicious cycle of dividend cuts, dilutive equity offerings, debt offerings at double-digit interest rates, and bankruptcies. The REITs that over levered and grew too fast at the top will disappear in bankruptcy. Others might fall into the low single digits by year-end as the market anticipates that creditors will take title to many properties in 2009 and 2010. These developments would push the value of the REIT Index to the bottom. $1.6 Trillion in commercial real estate debt is coming due…The REIT sector, just as the big banks were last year, is undercapitalized. If you mark the value of commercial real estate to market, it tells you that REIT debt — commercial mortgages, unsecured notes, secured lines of credit — is out of control. Equity cushions are practically non-existent. REITs don’t have to mark their assets to market each quarter like investment banks. The reality is that before committing to a secondary offering of REIT stock, institutional investors will mark property portfolios to market.

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Marking property to market will result in many underwater commercial properties. This is critically important because the combination of underwater properties (insolvency) and imminent debt maturities (illiquidity) tends to wipe out equity. The maturities over the next five years are staggering, and these debts were carelessly underwritten near the top of the credit bubble. According to Goldman Sachs research, roughly $1.6 trillion in commercial real estate debt is coming due 2009-2013.Lenders will not be willing to refinance mortgages in situations where mortgage debt exceeds the value of the property. In order for all of these $1.6 trillion in loans to qualify for refinancing, hundreds of billions in new equity will need to be injected into properties. New equity capital dedicated to commercial property ownership will not exist in the environment of 2009-2013; many of these loans will default. In a scenario of paying off staggering debt loads under stress, the claims of common shareholders are either diluted or wiped out completely.