Many market commentators have been predicting that commercial real estate is the next shoe to drop in the credit crisis. I've seen a handful of presentations with whopping statistics on the amount of outstanding debt that will need to be revolved in the upcoming years. However, there has not been the massive apocalypse in commercial RE. At least not yet.
And there actually may not be. At least for a long while. The reason is that early this year the IRS changed some rules to allow REITs to pay some or all of their dividends in the form of stock. Typically a REIT pays its dividend in 100% cash out of its funds from operations. Because it pays a certain percentage of all of its income as dividends, it gets favorable tax treatment as a REIT. Late last year when the credit crisis was in full swing, REITs suddenly had to reduce their dividends because their funds from operations were reduced. Additionally, the terms for renewing debt was highly unfavorable so many REITs were in a bind as to whether they could revolve the debt at all or even pay out a dividend. As you can imagine, failure to pay a dividend would cause investors to flee the REIT as the primary reason to even invest in one is for income.
So the overall prediction was that as REITs would need to renew their debt in massive proportions, the credit markets would continue to be frozen and many would become insolvent. However, that has not happened. Fortunately, this single IRS change has allowed REITs to continue to pay large dividends to shareholders by issuing the dividend partially or fully in stock. Thus, there has been no massive exodus and crashing of these REITs. With their stock intact or even elevated due to the recent market bounce, many REITs have even been able to issue stock to repay debt.
One potential side effect of this IRS change is that the current shareholder is diluted at each dividend payment. Essentially, by issuing more shares each quarter, the REIT is slowly diluting and watering down its own investors.
This form of dividend payment reminds me of PIK toggle notes. These "Payment In Kind" notes allow a debtor to defer payment of the debt and allow it to accrue for a certain period. In the LBO world, PIK notes are very favorable for the debtor because it allows the debtor to essentially change the terms of his loan if his cash flow is thin. As you can imagine though, the use of PIK notes are a clear indication of potential financial distress and in general are only issued during frothy boom times. Thus, it is surprising that in this time of financial crisis the IRS would allow payment of dividends in stock.
This either means that commercial RE will never have its projected crash. Or it means that the death will be slow and it will be inevitable.
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