Will REITS and private equity funds come to the rescue?

When is our economy going to recover and how is it going to happen? I'm sure many of you hear this question almost every day. It's a topic that haunts households, board rooms, conference rooms, and pretty much every room across the country.

To find the answer to a problem one usually only has to look as far as the source. The residential and commercial real estate booms were ultimately what led to our economy's decline. Overly optimistic underwriting, irresponsible lending, and the market's perception of real estate as a risk-free asset created an insatiable appetite for new commercial loans. The demand for new loans was met with huge amounts of capital flooding the commercial real estate market. In turn, the ample supply of debt caused prices to inflate beyond the true fundamentals. Now as pricing retreats, most of our lending institutions are realizing tremendous losses in the form of writedowns and have minimal, if any, new capital to lend. It's evident that real estate balance sheets need recapitalization in the form of increased equity. The only question is this: "Where is this capital going to come from?"

The government, and more importantly the Treasury, has made attempts to inject equity into the system. The creation of programs such as the Troubled Asset Relief Program and the Public-Private Investment Program has been relatively unsuccessful in cleaning up the balance sheets. Many argue against the participation of our government in the capital markets, but what's undeniable is the fact that these programs have yet to yield tangible results. Japan found out the hard way that when you depend on government relief programs, and grossly underestimate the amount of capital that is needed to fix the system, the desired results can take a long time to come to fruition. While the United States is creating policy much quicker than Japan did in the late 1990s, the same problems still exist. There isn't enough capital circulating in the market to fix the problem.

I'm making the argument that the capital is there, it's just on the sidelines. Consumer confidence and the lack of a defined bottom in real estate pricing have kept a majority of the discretionary income out of the market. If a real bottom is to be reached, then lending institutions are going to have to get legacy assets off of their balance sheets.

One of the major problems facing our lending institutions is that they are not in the business of real estate management. They may underwrite it and lend on it, but when it comes to running it and performing the necessary tasks to get properties cash flowing; they're lacking. The wave of foreclosures to come will create a log jam in the banks' operations unless they have a quick and relatively painless avenue to dispose of the loans/properties. That's where the real estate investment trusts REITs, for short and private equity real estate firms will play a vital role. Their livelihood is made on the acquisition, management, and disposal of real estate. REITs alone have raised $19 billion in new equity in the past year, and there is an estimated $173 billion waiting on the sidelines in private equity firms. These will be the willing market participants who will relieve lenders of their troubled assets. Lending institutions most likely will have to be willing to take a loss on a majority of their troubled loans. However, they will benefit from the freeing up of the required reserves they had to maintain on the troubled loans, as well as in the new loans that will be created through the new acquisitions.

If the lending institutions, and the government, allow this scenario to unfold, it will create a domino effect. Being able to acquire real estate at depressed values would allow existing investment companies to exit these under-water legacy assets and it would provide a real market bottom for new investors. Once a bottom is established and properties can be valued accordingly, then lenders' balance sheets will become more predictable and they will be more willing to lend. This in turn should jump start the real estate market as well as the economy in general. New businesses will require more space, lowering the vacancy number, which will increase real estate rents and values. Once values begin to increase then development will ensue and hopefully a healthy market will emerge from the ashes of the last. While this might paint an overly optimistic scenario, what are our alternatives? Lose a whole decade to stagnation?

Chris Shanks is an investment analyst in the investment properties group of NAI Alliance in Reno. Contact him at 356-4620 or cshanks@naialliance.com.