Double edged sword

If management discloses the effects of securitization versus bond financing, it will be a boon to shareholders

August 25, 2016

About the author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Between 2010 and 2020, Ganel worked for Silvergate as Vice President in Capital Markets. He provides advisory services to family offices,  private companies, and financial advisors.

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“Securitization involves the creation and issuance of debt securities, whose payments of principal and interest derive from cash flows, which are generated by a separate pool of assets,” notes Todd Keator of Thompson & Knight, a law firm. An Apartment REIT, for example, may obtain a loan by allocating a portfolio of residential homes to a separate entity.

There are obvious motivations. A securitization agreement contains less debt covenants compared to bond issuance. Management faces less regulatory scrutiny. And in the current pygmy interest rate environment, the securitization cost of borrowing is lower than debt markets. Moreover, lenders to REITs prefer securitization. He who pays the piper calls the tune. 

Securitization is less risky from the lender's perspective. Post securitization the lender is indifferent to the operating performance of the issuing company. If the company mismanages the real estate portfolio, the lender’s security is unchanged. Securitization also offers a senior position on rents revenue. The pass-through structure enables the lender to collect the rents first, to deduct the interest, and then pass the monies to the company.

Proceeds from securitization have proliferated in REITs. American Homes for Rent (NYSE: AMH), in five separate transactions, issued a total of $2.3 billion in securitization in the past two years. The company pledged 17,776 homes, out of a portfolio of 38,780 single-family properties, representing about 45 percent of the real estate portfolio. Management noted the securitization proceeds allowed the company pay down credit facilities and general corporate purposes. That is an understatement.

Securitization financed the operations of the company. In 2015, American Homes operating cash flow was $201 million, but investing cash flow, to acquire and renovate the residential portfolio, had used $885 million of cash. Alas, classified as financing cash flow, the inflow of $632 million in cash from securitization served an essential role. 

Gresham’s Law in modern economic thought is that bad capital structure drives out the good.  It is unsurprising that Colony Starwood Homes (NYSE:SFR) securitized its residential portfolio as well. Colony issued $504.5 million backed by 4,096 residential homes. After fees, the net proceeds of $477.7 million benefitted the company by providing a means to repay a portion of its credit facility and to acquire additional properties.  

Yet securitization true costs are hidden from financial reports. The risks from short-term financing, accompanied with a maturity balloon payment, expose companies to immeasurable risk. Because the credit crash of 2008 tarnished the reputation of securitization, it is little wonder that companies changed their classification. They are now called asset-backed lending.