Heavy Dealmaking Demands Scrutiny: Credit Analyst

Few companies monitor the credit markets as stringently as Manhattan-based Fitch Ratings. That explains why last summer Fitch hired real estate guru Steven Marks to lead its highly influential REIT surveillance group. Marks spent the previous eight years working as a real estate investment banker for Bear Stearns, where he acted as an advisor on $5.5 billion in public debt offerings.

With listed property trusts increasingly leveraging up to win deals, the stakes just keep getting higher for REIT bond and shareholders. It’s also forcing Fitch to be extra vigilant in how it covers this rapidly growing market. For Marks, this torrid climate can easily persuade REITs into making rash financial decisions in the heat of a deal. NREI recently spoke to Marks about this frenetic market and the unique demands that it’s making on REIT investors.

NREI: The NAREIT Index yielded an absolute return — meaning how much an investment appreciates over a set period — of 32% in 2006. How likely is it that the REITs can meet or exceed that threshold this year?

Marks: It’s certainly possible. When you have such huge demand to take listed REIT portfolios private at such large prices, you have to expect that the takeout premiums will boost share prices. But valuations are still well ahead of improvements in real estate fundamentals.

NREI: Are buyers really concerned with present-day fundamentals or is the market so intensely speculative today that overly optimistic income and appreciation projections are luring investors into deals?

Marks: You could make the case that sub-sectors like the office market are steadily improving, so values already reflect that baked-in value increase.

NREI: What issue should REIT investors be focusing on today?

Marks: Most people don’t pay enough attention to fund flows. They’ve been positive into the REIT sector since 2002 at a very strong rate. But they can reverse course very quickly, and we don’t hear many people discussing that outcome. It’s somehow easy for many people to forget that capital stopped flowing into technology stocks almost overnight a few years ago.

NREI: What worries Fitch on the debt side?

Marks: We’re always concerned about leverage discipline. Most REITs can’t pile on debt the way that private companies can on an acquisition. (REITs rarely exceed 60% loan-to-value) That’s healthy, but as prices continue to climb, it’s inevitable that REITs will require more debt to get the deal done.

NREI: Based on that, should we expect to see more companies teaming up on deals in 2007?

Marks: Absolutely. More capital sources will spread the risk out better between partners. The joint venture structure allows a group of buyers to increase the size of their offer. I’m also expecting to see more mixed joint ventures whereby a REIT and a private equity fund team up.

NREI: But can’t joint ventures become sticky situations, especially when it’s time to exit an investment?

Marks: Not if the partners agree in advance on what their operating and exit strategy is going to be. We see REITs working with all sorts of private companies (and other REITs) on joint ventures. If these deals are structured carefully in advance, they can work very well.

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