The reinvention of commercial real estate is underway, as seen in creative deals ranging from Brookfield’s debt offering to Transamerica’s recent Opus East/Rainier financing. A range of structures has emerged across the U.S. and Canada to take the place of now-frozen CMBS markets. Of note, however: access is bifurcated, making this still the purview of the privileged. Even so, it is good news that several substitutes are now emerging in place of CMBS, with structures ranging from sale-leasebacks to equity-linked debt and, for the lucky few, CTL financing as well.

Real estate owners are now bifurcated in one of two directions: those with credit-rated tenants get preferential access to otherwise squeezed credit markets. Those without are forced to dig deeper into equity-linked options, some of which rest on their own credit quality. Transactions range from straight equity issuances, to convertible debenture offerings to complex sale-leaseback transactions. This sort of creativity is necessary, as commercial real estate markets are facing somewhat-scary territory: real-estate securitization markets remain functionally closed; banks have removed themselves from many parts of the lending game; and a $400 billion base of existing debt requires refinancing over the coming years.

Simple equity offerings, dilutive though they may be, are a cornerstone of the big recent push toward REIT (re-)financing. These financings are driven in equal parts by opportunistic new entrants and refinancing existing players. These offerings present a cross-border trend – in the U.S., the U.S. REIT markets have been busy with many an offering this fall, including Starwood Property Trust, Apollo Commercial Real Estate Finance Inc. and Colony Financial. For more on recent U.S. REIT IPOs, see the previous Westlaw Business Currents articles REIT IPOs: The Risk of Going Blind and REIT IPOs Rising: Not Your Mother’s Public Offering, available in the Related Resources panel.

North of the 49th, Canadians are witnessing a mini-flood of REITs issuing securities. These issuances are evenly split between equity issuances by the likes of Brookfield and Chartwell (both of which have issued units in recent weeks) and convertible debt sales, by REITs from Primaris to Cominar to the friendly-sounding Scott’s Trust.

Balancing sensitivity to constricting covenants and dilutive equity, these convertible debenture offerings offer another equity-linked route to refinancing. Their structure is driven by legal limitations inherent to many a REIT, typically restricted in their debt load by tight Debt/Book Value Ratio covenants. With a REIT like Canada’s Primaris Retail Real Estate, the Trust is limited to 60% debt-to-gross book value assets (excluding convertible debentures). And this is the key: issuing these equity-linked bonds lets the REIT stay compliant with covenants under its Trust Indenture, while not over-dilutive. As a side note: a REIT like Primaris has conservative debt instruments with the average term to maturity to 9.3 years from 6.2 years at the end of 2004, which should improve cash flow stability over the next few years.

As one example of how this plays out, consider Primaris’s recent $75 million dollar offering of convertible unsecured debentures. This REIT owns shopping malls and regional strip malls with credit-rated tenants including Sears, Wal-Mart, Home Depot, and Canadian Tire. RBC was the chief bookrunner. To date, Primaris’s acquisitions have been financed with both mortgage debt and new equity, to maintain leverage at reasonable levels of 52% on the basis of debt-to-gross book value assets (excluding convertible debentures of $12.5 million).

More broadly, convertible debentures are an instrument of choice for Canadian REITs, including OMERS, Primaris, Artis, Cominar, Scott’s REIT, Crombie. The choice of security structure is telling – essentially, these are equity-linked debt, that, like preferred shares, serve as a hybrid, mid-capital structure. They are unsecured, mostly shorter-term (15 years or less) and lack specific properties as collateral. The issuer accounts for these separately from other forms of debt, opening the door for later, equally separate securitization. As to payments, the coupon varies along with the term of the debenture offering and the credit rating: longer term AAA paper offerings have coupon rates of 4.5-5%, while shorter term BBB paper offering coupon rates of 8-10%.

With credit risk driving so much of the market, the luckiest of the group are landlords of highly rated tenants who lend their aura of credit-worthiness to the landlord itself. There are several preconditions to this, among them the need for the property to be a large single-tenant office buildings and/or retail asset. This group may have what is referred to as a truly bondable triple net lease, which basically means the landlord really bears no real estate risk (i.e. responsibility for anything regarding structure, utilities, taxes, or insurance). The landlord simply has to be an expert at picking up his or her check for the rent.

These credit obligations from the lessee to the lessor have no real hiccups or “hair” on the deals, i.e. factors due to which the landlords could hypothetically be charged for expenses. As a result, the income streams are real fixed annuities and the capital markets can truly “bond” the leases and offer them via the capital markets as bonds.

Coupled with the minimal credit risk associated with the high class tenant, the landlord is able to access special financing structure, known as CTL (Credit Tenant Lease Loans). This is the modern real estate equivalent of Nirvana, allowing for relatively high leverage, as high as 85%, notable when other credit markets are far less giving. This is available, as a general rule, assuming the tenant is of an investment grade or better (BBB or better). This financing makes run-of-the-mill landlords green with envy, as they do not qualify for it under a more standard arrangement. In those cases, the landlord absorbs some if not all management upkeep and expense risk.

Underwriters include investment banks of Royal Bank of Scotland, Royal Bank of Canada, and CapLease. Niche players appear in this market to act as both the issuer and the underwriter. An example would be the regulated broker-dealer, Cornerstone Capital.

Sale-leaseback transactions present yet another option, particularly for those lucky enough to have sterling-rated tenants. In these cases, a two-step sale-leaseback transaction provides yet further access to credit, given the credit-rated tenant. These large sale-leasebacks allow the creditor to monetize real estate and redeploy the capital into its core business.

Consider the case of SunTrust, which in the first two quarters of 2008 the Company completed corporate sale-leasebacks of 149 branch properties and office buildings. The net proceeds from the sale were $245.3 million. Since the lessee of this corporate-guaranteed lease is SunTrust, investors are buying the investment grade obligation of SunTrust and are not driven by the real estate decision as much as the credit rating of the tenant. Drugstores such as Walgreens and CVS are often packaged in portfolios and sold wrapped with this type of financing.

An example of single tenant asset that was originally structured as a sale-leaseback conducive to credit tenant lease financing was the Brookfield/JP Morgan relationship, where, in 2007, Brookfield bought and leased back to JP Morgan the 750,000-square-foot Chase Tower in Phoenix and the 412,500-square-foot North American Technology Center in Houston. They sold the assets after the sale-leaseback.  JPMorgan anchors both those buildings under 15-year, triple net leases originally signed with Brookfield.  Prior to the sales, Brookfield had 928,000 square-feet leased to JP Morgan in the United States and JP Morgan had a AA- credit rating at the time.

Sale-leasebacks are available not only with the sterling-level credit of blue-chip companies, but with the full faith and credit of government behind it, where various government agencies are tenants. The Canadian government itself took advantage of this trend in late 2007 structuring seven sale-leasebacks on 1.41 Billion dollars worth of federal office buildings with RBC and BMO Capital Markets prompting the Crown to sell and leaseback.

So did the U.S. government in the landmark situation surrounding Transamerica (Aegon) and Opus East. This situation showed that lenders can go further in their quest for financing – going so far as tweaking existing underlying leases to allow them to qualify for bond-friendly financing of the type outlined above. In this case, a bankrupt Opus East asset had the Social Security Administration as a tenant, and ended up in the lap of its lender, Transamerica (Aegon). Opportunistic fund Rainier Capital saw an opportunity and insisted it would help Transamerica move this undesired asset – if only the lease were modified. These modifications in the agreements, including the lease, made this asset much more attractive for sale.

The credit market is like a machine. Investor demand is on one side of the table dictating the perception of risk and what premium the investor will require on certain investments relative to the risk free rate (treasury bonds). The conclusion thus far: investors would rather be general creditors to investment grade companies than secured lenders on specific assets.