Euro Debt Casts Shadow on REITS

Terry Flanagan

All roads may no longer lead to Rome, but it appears all global financial markets will be impacted by actions the Italian government takes to rein in its massive debt burden and avoid a sovereign default.

That includes markets as specific as real estate investment trusts (REITs), which have been favorites of banks because of the attractive premiums on financing they provide to those borrowers.

“Relative to lending to a company like IBM for somewhere around 50 basis points over, REITs can provide 200 to 300 basis points,” or 2-3%, on a loan, said Lowell Bolken, associate portfolio manager at Advantus Capital Markets. He added that banks have been highly competitive compared to more traditional capital markets sources of REIT funding.

That has helped the performance of REITs focusing on investing in commercial real estate remain relatively strong throughout the economic downturn, even as retailers and other tenants have faced headwinds. That may change with a European sovereign default.

Bolken notes that Deutsche Bank, Credit Suisse and UBS are among the European banks that structure and underwrite commercial mortgage-backed securities for REITs, and banks such as HSBC act as direct lenders. Deutsche Bank, he says, has already started to scale back its financing activities.

Those banks are all big investors in European sovereign debt, and a default would almost certainly curtail their lending. “So if there’s a funding freeze, that will change the cost of capital [for REITs] at the margin,” Bolken says.

U.S. banks could remain viable lenders to REITs, except that no one knows the extent to which they’ve written credit default swaps giving them exposure to European sovereign debt or the banks that hold it. “That’s where the ripple effect comes into play,” Bolken says. “U.S. Banks may hold some exposure through CDS and will have to recognize it.”

U.S. banks may then have to bolster their capital as well, increasing cost of their loans just as U.S. lenders appear to be lending more freely to smaller businesses following the 2008 credit crunch.

“The mom-and-pop retailers haven’t gotten the financing a large national retailer gets,” Bolken says.

Another broad credit crunch prompted by a sovereign debt default could reverse any recent lending gains to those borrowers, stalling their expansions and even resulting in more bankruptcies. That’s a problem for REITs investing on shopping malls and other commercial real estate.

“That worries us when we look at the macro picture. Small business is where a lot of the job creation occurs,” Bolken says, adding that while REITs would certainly be impacted by another economic downturn, they are better positioned to whether the storm than other sectors.

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