A Novel Solution to the Commercial Real Estate Problem

The Financial Times has an article about one group’s plans to refinance commercial real estate. Their plan is to not refinance all of the maturing debt with more debt. They plan to use equity.

The idea is to refinance existing CRE with equity raised via a REIT vehicle. The REIT would hold title to the properties but the current owner would continue to operate the properties. The owner would pay the REIT a dividend from property cash flows which would be passed onto the REIT shareholders. The article suggests that shareholders would receive something in the neighborhood of 5% to 7% on their money plus an inflation premium which would be based on the local rental inflation index.

A successful owner/operator would keep any rents above the inflation adjusted dividend but would lose the property if he was unable to maintain the dividend. The REIT would receive 20% of the profits from the sale of the property and the owner would keep the remainder.

Given that there is for all practical purposes no market for CRE debt or at least only one that is prohibitively expensive, this structure has some merit. In fact, even if there were a market, the idea has merit. Rather than trying to squeeze excessive profits out of piece of real estate by taking excessive risk via debt financing, the REIT structure settles for more predictable and far less risky cash flows.

I suspect that at this point in time there are more than a few investors that would settle for an inflation protected return of the magnitude forecast here if it also involved a slice of future sales proceeds. There’s also little reason why some very modest amount of leverage couldn’t be employed to boost the return somewhat.

It will be interesting to see if this plan can survive with healthy debt markets. From an owner’s standpoint there is a lot to like about it but the returns that accrue through leverage are hard to ignore. I suspect that human nature and greed dictate that leverage wins out.

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