CapitalSource Shifts Gears With Move To REIT Status 

CapitalSource Shifts Gears With Move To REIT Status

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There wasn't much buzz on Wall Street when CapitalSource (CSE) spent $211 million in January to buy 38 senior housing properties scattered from Texas to Massachusetts.
Nevertheless. both moves mark a major change for CapitalSource. The company writes loans and finances debt for small and midtier companies. many of which are unable to borrow through banks and other standard channels.
REITs are stock-owned companies that pay little or no income taxes. Instead. they pass most or all income directly to investors as dividends. For CapitalSource. the designation would cut its costs. giving it the ability to offer loan products below the rates of most non-REIT competitors.
The advantage is not without trade-offs. REITs must pass 90% of their earnings on to shareholders. That leaves little cash for company growth. When REITs need cash to grow. they must resort to equity offerings.
Earning REIT status also involves significant change. To qualify. a company must invest 75% of its assets in real estate. It must also earn 75% of its gross income from real estate-related sources.
CapitalSource took a big step toward satisfying the first requirement during the first quarter. growing its assets under management 83% from the prior year to more than $12 billion.
The largest piece of that growth was in mortgage-related receivables and mortgage-backed securities. Combined. these two assets increased 1.400% to $5.7 billion during the first quarter.
"Those assets will earn little or no income. they are purely for the purpose of qualifying for the REIT status." said Bear Stearns analyst Sameer Gokhale.
"Under the REIT rules it's really difficult to make a lot of money with that kind of asset unless you are taking a lot of risk." he said. "We don't intend to take a lot of risk."
CapitalSource's profit comes from its loan portfolio. which grew 7% in the first quarter to $6.43 billion. The company specializes in complex loan arrangements ' just the sort of thing many mainstream lenders shy away from.
Loans on which payments were delinquent 60 days or more increased 8% in the first quarter to $219 million. These loans represent about 3% of CapitalSource's total loan portfolio.
Revenue for the quarter rose 74% to $242 million. Earnings gained 27% to 42 cents a share. Analysts polled by First Call see full-year earnings climbing 41% to $1.87 a share.
CapitalSource typically makes loans to companies with $5 million to $250 million in annual revenue. Loans are usually between $1 million and $75 million.
Both deals were in January. and both were sale lease-back arrangements. That means CapitalSource purchased the actual property and facilities. then leased them back to the former owners. which continue to manage the operations.
The deals bulked up CapitalSource's share of revenue coming from real estate-related sources. which in turn pushes the company closer to earning its REIT badge.
Residential REITs began downshifting late last year. Many REITs reduced their dividends to shareholders. More than a few found themselves constrained by lack of cash flow.
"On the residential side. companies ' influenced by shareholders ' in many cases are wanting to get out of that REIT status. editor and publisher of the Web site Mortgage.
Performance-wise. residential REITS are still outpacing their commercial counterparts. The National Association of Real Estate Investment Trusts (NAREIT) lists 32 U.S. mortgage (rather than equity) REITs. which carry a market value of more than $25 billion.
Twenty-one of those deal with residential mortgages and have grown 9% so far this year. The 11 commercial mortgage REITs grew just more than 5%. Collectively. the group averaged dividends of $10.05. That's a lot better than last year. when NAREIT reported the group shrank 29%.
Fink calls 2006 is "a transition year" for CapitalSource. The extent to which the Internal Revenue Service considers the company a REIT will be determined from year-end reports.
If the IRS agrees. CapitalSource's tax rate will be lower this year than last year. and lower still in 2007. That's likely to push growth of CapitalSource's real estate portfolio ahead of its corporate business.
Debt rating agency Fitch placed CapitalSource on a negative rating watch in September. when the company announced its REIT strategy. Fitch removed the watch last month and affirmed CapitalSource's BBB rating.
The rating is Fitch's lowest investment grade mark. It's one notch below the BBB rating for Istar FInancial. (SFI) the only other mortgage REIT rated by the agency.
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