The trend toward securitized financing and investment has driven the real estate capital markets almost full circle from the early 1990s, according to some participants in the Investment Banker Roundtable and Breakfast, sponsored by NATIONAL REAL ESTATE INVESTOR and moderated by Donald R. Ciandella, NREI's New York contributing editor, on Nov. 18, 1994, at the RIHGA Royal Hotel in New York. But will higher interest rates and the return of traditional lenders take a bite out of the market in 1995? Investment bankers say securitization will continue this year, with the bulk of the activity in the commercial mortgage-backed securities arena. Both REITs and conduits face a more uncertain future.

Investment Banker Roundtable Participants:

* Ed Casal, senior vice president, Dillon, Read & Co. Inc., New York.

* George E. Carleton, vice president, Insignia Mortgage & Investment Co., Washington, D.C.

* Patrick Grasso, managing director, Eastdil Realty, New York.

* Pete Dayton, managing director, Cushman & Wakefield, San Francisco.

* Tom Lavin, managing director, Smith Barney Inc., New York.

* Keith Locker, associate director, Bear Stearns, New York.

* Ray Mikulich, managing director, Lehman Brothers, New York.

* Ethan Penner, managing director at Nomura Securities, New York.

* Diana Reid, managing director, C.S. First Boston, New York.

* David Rupert, vice president, Salomon Brothers, New York.

* John Westerfield, principal, Morgan Stanley Realty Inc., New York.

NREI: Thanks in large part to the public markets, capital returned to real estate in a big way last year. Is liquidity here to stay? What role will securitization play in the real estate finance markets this year?

Mikulich: Securitization is going to continue, but I think you're going to see more debt and less equity in 1995 for a couple of reasons. The prices at which new REITs would have to come to the market today suggest there are very few that will come to market. If we do see any activity, my guess is it will more likely be in the form of C corporations than REITs. That is not to say we won't see secondaries by existing companies. The M&A (merger and acquisition) activity will create or cause existing companies to accumulate more capital through the issuance of partnership units or stock for property. That is where the bulk of capital will come from or be created. The debt markets will be more active.

Casal: I see an awful lot of capital out there for 1995, but what we see is the capital becoming much more discriminating -- particularly in the REIT market. It is a bit like a marathon where everybody starts in the pack. But now the pack is breaking up, with the haves and have-nots. As people take the time to understand these companies and that they have different types of properties and opportunities, you are going to see more merger activity between REITs. You are going to see more private transactions in portfolios being transferred around and swaps between REITs. Some of the mixed-use companies may try to get more focused. Some of them will be recapitalizing to get rid of floating-rate debt. You are going to see a lot of cleaning up of balance sheets. It just won't be as automatic in 1995 to say let's hit the REIT market or the CMBS market.

Grasso: Both debt and equity markets are seeing dramatic recovery, and we see a significant return in a very competitive way. A lot of money is coming in from opportunity funds that were formed in the last two or three years and the return of pension money.

Dayton: Pension fund investment is clearly on its way up and the larger public funds, particularly those that have now got a decade's worth of experience behind them, are showing signs of being really comfortable walking into these markets. There are high-grade, intrinsic value (properties) at good yields. It astonishes me how many offers we are getting for suburban office buildings and apartments -- 10 offers within a 5% window for fairly aggressively priced assets. At least that was last week. I think there is a perceived liquidity that makes pension funds more comfortable.

Lavin: The private markets will reassert themselves to a certain extent in 1995, as they continue to adapt to the public markets. If you look at the traditional lenders like banks and insurance companies, they are definitely becoming a major factor in the market. It's really hard to say if there is any kind of liquidity crisis in real estate any more. If anything, we have multiple lenders chasing the better projects. Lenders that don't have the balance sheet capacity they had in the 1980s are going to use the public markets to fund themselves; insurance companies and banks are going to trend toward bundling and securitizing as opposed to keeping the debt on their balance sheets, at least keeping the investment-grade portion of the debt on the balance sheets. What you are going to see is more of a mix between public and private market activity, but the private market activity is going to be somewhat conditioned on public market take-out.

Casal: 1993 and 1994 are going to be known as the time when there was a fire sale on capital driven by the Fed and there was this huge basis point spread that was available. It was a time to go out and get some money. Now it is different. You are going to get back to the fundamentals and understand what it is you have and try to manage the new constituents in your company, whether they are bondholders or whether they are mutual funds. Many of the mutual fund investors, you have to remember, are not long-term, patient investors. They have stable sources of capital, but their attention span can be a nanosecond and they can react on it very quickly. Over time, as the pension funds get in and focus more on total returns, that will bring more stability to the REIT market. In the interim, as the mutual funds are really dominant players in equity, you are going to see a lot of volatility.

Lavin: Direct securitizations are very attractive for regional malls but less so for individual and small pools of office buildings. I think hotels are going to be an important factor in the public markets in 1995. We have got a number of hotel operators who are going to go public this year in the C corporation format as opposed to the REIT format. What they look at are really tax efficiency vs. an ability to retain free cash flow that bolsters the company's credit and provides funds for reinvestment in a growth market. The initial reaction (to hotel REITs) was actually quite favorable until the recent selloff in the entire REIT market. I think everyone uniformly agrees that the underlying economics of the hotel business are going to be quite good for the next three, perhaps five years.

NREI: Will the CMBS market be hurt by the rise in interest rates?

Penner: Despite the fact that interest rates are up 200 basis points and that the RTC, which was a major provider of product, is gone, the commercial mortgage-backed securities market is seeing its highest volume ever. It is defying all logic. It is driven by the fact that institutional fixed-income investors are desperate for product that has got a good risk/return profile. The one slice of the capital markets that will be phenomenally strong in 1995, despite what happens to real estate, is CMBS.

Westerfield: The CMBS market will continue to be a strong source of capital for the real estate industry in 1995 simply because the terms are getting better. It hopefully can be more like making Model-Ts than Ferraris for all of our collective sakes. One of the drivers of the CMBS market in 1995 is the return of private capital to real estate. There are still a lot of companies out there that still don't have the right capital structure, that are overleveraged. With the public markets out, the opportunities for hedge or vulture funds to provide structured mezzanine financing for poor equity is going to be substantial. Those people finance with the CMBS marketplace. It's faster; it provides different kinds of terms; it's more flexible with respect to your operating strategy for disposing of assets or working investment toward a public market exit. You will see that trend continue on the equity side and, as a result, more CMBS will spit out as a part of it.

Carleton: Regulatory and accounting changes for insurance companies and banks will escalate their demand for high-yield real estate securities vs. whole loans. With initiatives for better reporting and the first round of re-rating complete, more institutions will be capital suppliers of initial and secondary market debt securities.

Reid: With rate increases, difficulties for REITs and uncertainty about what the correct yields should be on non-investment-grade debt, a significant factor in 1995 is the real crossover between the yields you can get in equity and the yields you can get in debt. The question is not is there money to invest, but really what kind of control are you willing to give that money. Therefore, a question on everything that is non-investment-grade on the debt side will be: is it better to put that in some form of mezzanine equity and give the investors the control and access to those assets that they really want and need. Many investors that are focused on that area of the market are very knowledgeable about real estate, and they want more equity-like aspects like that.

Locker: In terms of private capital and especially the pension fund money coming in, they are focused on going after the mezzanine piece of the capital structure in highly engineered transactions where those players are more comfortable with higher levels of debt than a public company. It will use that mezzanine portion to carry various rights much stronger than, let's say, a B piece of debt securitization. And we may see a lot of transactions, and maybe there are various companies that thought about a REIT vehicle being recapitalized with some commercial mortgage-backed securities, a mezzanine piece and lastly with an existing owner holding a junior piece of debt for equity.

NREI: How will the CMBS market coexist with commercial banks that are becoming more aggressive?

Penner: I think the banks have historically made all the wrong moves. The way I see most of them playing today is providing acquisition financing to REITs, (but) it's absolutely just the wrong time. And they are doing it now for many REITs on an unsecured basis, which is potentially catastrophic, at extremely tight spreads. So they never have really been nor are they today a true player in the business of doing permanent mortgage financing. That business has historically been and is today more of an insurance company product than a bank product, although there are exceptions to that. Insurance companies are the kind of veterans in the business of lending that are going to take some of the steam out of the CMBS market. But as long as greed doesn't overcome Wall Street and the institutional fixed-income investor, we can compete with an insurance company for appropriately priced risk. I think the market is going to take the path of the single-family mortgage finance business where securitization and institutional investment securities have cheaper cost basis than portfolio lenders, and they can afford to price things tighter.

Mikulich: We hit all-time low spreads against Treasuries for a $200 million portfolio of regional malls in November. And we did a five-year deal on a mortgage equivalent of 63 basis points off, which is staggering when you recognize that a year ago the spread would have been closer to 100 basis points.

NREI: The rise in interest rates and the retreat of mutual funds from stocks in general has hurt REIT price shares. Will REITs rebound in 1995?

Rupert: Two things are going to determine equity securitization. It's a pretty simple premise that people buy stocks when they go up (so-called momentum investing). Unfortunately, REIT stocks have not been going up, and one determining factor is interest rates. We see interest rates sideways to down at the end of 1995, with some short-term uncertainty before that. Interest rates are going to be a determinate because the balance sheets of a number of REITs are interest rate sensitive. Also, the mutual funds that have been funding REITs have been investing as yield alternatives and not as total return vehicles. In 1992, you could buy a REIT and pick up 400 basis points and an 8.5% or 9% dividend yield. That's pretty compelling. It caused money to go into the REIT sector just for returns. In 1993 the same thing applied. With the rise in interest rates in 1994, you are talking about only 100 basis points differential, so roughly a quarter of the premium that existed in 1992 and 1993. If you are just purely buying REITs for their current yield you are much less anxious to do so now. That is one of the reasons why we think growth will be difficult next year unless we can find a substitution for mutual funds' capital. What we are seeing is that pension funds are slowly starting to replace mutual funds as a net provider of capital to the REIT markets. Instead of just being yield oriented, they are total return oriented and they understand real estate fundamentals. We think this will be very positive for the industry going forward.

Locker: There's going to be an across the board consolidation in 1995. The Holly (Residential Properties Inc., Tacoma, Wash.) and Wellsford (Residential Property Trust, New York) merger (in 1994) is one example of what you'll see. And you are going to see portfolios and partnerships going into REITs.

Westerfield: This is going to lead to a market of haves and have-nots. Some of the companies that have promised a lot and gotten their analysts on board are going to disappoint and really be shut out of the capital markets in 1995. But there is going to be a group that is going to hit their target and perform well. Those companies are going to have to access secondary capital as well as the corporate unsecured market for REITs. That market has taken off to some degree. We were involved in $600 million worth of deals in 1994 and there's a good pipeline for 1995. That kind of financing at the corporate level provides enormous flexibility and allows these companies to move quickly. They basically can act as corporate issures. Financing costs are very low. Secured financing costs are much more. Capital is going to give the haves the ability to acquire the have-nots and to consolidate their businesses going forward.

Rupert: The theme there is creativity. What is likely to happen is that all the tools in the toolbox for the typical chief financial officer of an industrial corporation are now being made available to CFOs of real estate companies. They are primarily being made available to those who are large enough and have the credit quality to become investment-grade. Unfortunately, we are talking about a group of 15 or so entities at this point. As the industry grows and matures through consolidation and selective acquisition of assets this number will substantially increase. What these companies have access to is the unsecured debt market and some of the creative structures used there. One example is the issuance of capital with derivatives as was done recently by United Dominion in a 30-year, put 10 structure. Transactions of this nature tend to build upon one another; it's a lot easier to issue a more complicated transaction if you have three or four straight unsecured bond transactions already out there trading.

NREI: What strategies should existing REITs pursue?

Rupert: I think it will be interesting to see how REITs react to the inability to access the public markets. What that prompts is a question: if I'm a REIT, how can I compete today if the pension fund capital is competing for the same assets, driving up the price of assets while my cost of capital is rising? There isn't a large enough spread between the two. What we are finding is some REITs saying, "We are going to hit them where they ain't," where pension funds dislike playing. That includes tax-exempt financed assets, properties in which the debt can't be prepaid and assets that have a high-risk profile like value-added properties.

Another question is, what price will I have to pay for my asset in 1995 if the huge driver of this market, which has been acquisitions by REITs, is substantially diminished? I think the logical answer is the prices are going to go down. I think you are seeing evidence of that. Another alternative strategy, in a capital market where a REIT has limited access to new capital, is to selectively sell properties to those that have capital and redeploy the proceeds into higher yielding properties.

Westerfield: I think there is still really tremendous opportunities at the bulk level. You know the bulk sale calendar has fallen off but there are returns on those portfolios because, with the liquidity, you can sell those portfolios on an individual basis. Those assets are phenomenal. We bought $500 million in assets in the last three months. One of the portfolios we have virtually returned already and that is because of the liquidity at the private level for smaller assets. I think that is going to continue.

Grasso: Aside from a lot of the distressed sellers over the last few years, we are seeing some discretionary sellers coming back to the market for the first time. The larger institutions are rebalancing their portfolios and selling institutional-grade product back into the market again. Hopefully, the new capital will again draw out additional product to meet that demand.

Dayton: For institutions, it's clearly a strategic readjusting rather than getting rid of the accidents of the past. We are seeing much better quality assets. (But) pricing is still a tremendous risk.

Locker: If I was a REIT manager, I would be focusing on increasing and maximizing cash flows for my existing portfolios. Everyone has talked about this recovering market and I think there is a lot of opportunity (one) to start pushing rental rates, especially in the apartment sector in various markets. Two would be, if the public equity market is not there, to look at using a little more leverage on my balance sheet. And while that may cause some analysts some concern, if it is properly structured on a fixed-rate basis with an appropriate term to maturity, I think that could provide some positive leverage and create some shareholder value. Three, if I was looking to raise equity and the public market is not there, I would consider doing a private deal directly with one of the pension funds. So I think REIT management can still have their hands full through 1995.

Reid: Although there's a wide variety of money ready, willing and eager to invest in some form of equity or debt real estate, the real question is whether or not there will be a supply to invest in. Despite the recovery, there are still hits that have to be taken by the sellers in order to match the kind of prices that new money wants. With the more positive tone of real estate recovery, I think there will be fewer willing sellers.

Penner: Given where dividend yields are for REITs today and factoring the cost of raising equity, they are not buying any properties.

Mikulich: I think we are on the brink of having too much liquidity in the real estate markets generally. Somehow we are going to collectively move loan-to-value ratios up and the spreads down. Yes, there is anecdotal evidence of prices actually going down for some multifamily properties, but if you step back and look at the whole macro, there is a lot of capital that has come into this sector that is unspent. The institutional and individual investor community says on a relative return basis REITs were horribly overpriced, yet you have a lot of private capital coming in at these price levels. The return hurdles for real estate are going to come down in which case I suspect the public companies get priced out of the real estate market for six months or maybe a year. And then the question is: will this new capital get siphoned back off into other things because there are higher returns in other segments of the economy.

People are already trying to figure out where they are going to get the return that they promised people. This is a sign of a market that is going through some very fundamental changes.

Dayton: None of which has to do with the real estate, bricks and mortar. Everybody knows that Los Angeles County is a disaster. Yet when we put 300 units of B apartments on the market in the fall, we got offers, six of which were in single digits (caps), for $40,000 per unit for a project that none of us would buy for our grandchildren.

Mikulich: But real estate values have always been driven much more by the supply of capital.

NREI: Many have talked about the inability of many conduits to deliver loans to borrowers. And consolidation has started to occur. What is the future of the conduit business, and what can borrowers expect?

Penner: The conduit market is probably the most overused and misused word on Wall Street; it's like risk arbitrage was in the 1980s. Everybody on Wall Street says they have conduits or plan on having conduits. We also have engaged in a process of originating mortgage loans through the conduit process, but, in all candor, it is less than 5% of all the mortgages that were originated last year. It probably will be a similar percentage of outstanding loans in 1995. There are many reasons for this not the least of which is that the trend really began through the REIT processes -- the consolidation of ownership into the hands of larger organizations that don't go for $1 million or $5 million mortgage loans. They go for $50 million to $200 million cross-collateralized borrowings. These trends are at odds with each other. The preponderance of larger holders of real estate and their ability to access more reasonable capital through larger borrowers boded poorly for the whole conduit concept last year and that trend is probably not going to change.

And there are other reasons for what I would characterize as a general failure of conduits -- it's not easy to manage a large system of brokers, which is what people put together, and to communicate a sense of consistency to deliver loans to borrowers that are looking for that warm and fuzzy feeling. It is very difficult and it also takes years to develop. People are very skeptical about sources of money that they really can't put their hands on and, frankly, Mr. Main Street is skeptical of Wall Street as kind of the new lender in town. When they hear from their local broker that they just got a $200 million commitment from X in New York, that doesn't necessarily always play that well in Tennessee when you are competing with the local bank who they know has money.

Grasso: A big reason for the uncertainty in the conduit market is the fact that it was so new. You didn't know whether or not there would be a deal at the end of the day. Secondly, it wasn't cost effective. With a new system put in place and the loads up front, there has been an established correspondence system out there for a lot of small loan companies that I think is cost effective. I think there remains a demand for the small loans and everyone isn't consolidating everything into big packages.

Carleton: The conduit market is going through an adjustment in that its niche is being redefined. In reality, too many players crowded into a thin market segment. There's been inadequate communication of the strict underwriting guidelines to borrowers, causing widespread dissatisfaction. Conduit document or legal modifications are rarely allowed. And the scrubbing of net operating income must be consistent within each underwriter's pool.

NREI: Outlet center developers were active in 1993 and 1994 on the public markets. How do you see this market?

Lavin: They started to have their problems before the rest. It is quite interesting because you can point to a particular event that really triggered a big selloff in the shares of the outlet centers. That was McArthur/Glen Realty missing its distribution numbers by a fairly wide margin. The stocks are still substantially off their highs, but most of the companies have actually been hitting their numbers pretty well. A number of the companies have really been performing quite well and it is really turning into a business of haves and have-nots. It wouldn't surprise me to see some acquisition activity in this sector as well.

NREI: I think they seem to feel that they didn't communicate well with the investors in terms of some slow lease-ups that they were having. Do you agree with that?

Lavin: I think that was some of it, but I also think they were the people who looked like they could offer the most growth and, therefore, they probably had the most volatile set of shareholders. I'm talking about the growth mutual funds that continually move on to the next sector. I think there wasn't a lot of understanding of the fundamental business in the companies on the part of a good number of the original investors in the whole sector, so it was one that was almost ripe to have a selloff in the face of a problem. The managers, bankers and analysts spend a lot of time with the companies in going over the press releases and in trying to help them communicate. But let's face it, it is always a learning experience for a new company to deal with the public markets, particularly real estate people who have been intensely private for years and years. There also has not been the depth and breadth of research in the REIT field that there has been in other sectors of the securities markets because there has been so much issuance. One of the benefits that will come from the current pause in IPO activity is that the street is going to catch up on a lot of the research that is owed to clients and investors; and also, obviously, as people spend more time with these stocks, they get more familiar with them, they ask more penetrating questions, and they have a more profound understanding of the property type of the business. So I think part of it is communication, but it is also that the starting knowledge base was pretty slim in most cases. A lot has happened very quickly.

Locker: The outlet industry experienced a kind of double-whammy: On one hand, the overall REIT market and investor sellout on a wholesale basis and, secondly, as Tom pointed out, specific investors' disappointment in some of the disclosure at some of the companies and some of the delays that the companies experienced in getting their products on line. But, overall, the fundamentals of the companies are pretty strong in terms of hitting their numbers, continuing their development track. The other factor in the amount of competition among the companies to build new centers. Some feel the competition has driven down returns of the underlying properties because of higher outlet tenant costs and higher construction costs.