By Art Gering
REIT unsecured debt stacks up well against other corporate fixed-income securities, but what factors could alter the outlook?
As of March 2004, there was $4.5 trillion of debt in the corporate bond market,
according to the Bond Market Association. Thierry Perrein, a director at Credit
Suisse First Boston, says that of that $4.5 trillion, approximately $69 billion are
outstanding REIT bonds. Although the $69 billion of outstanding REIT bonds is easy to miss in the larger corporate bond market, REIT debt investors would argue that REIT bonds stand above the crowd because of the unique advantages they possess.
Much of the edge REIT bonds are said to hold over other corporate debt stems from protective debt covenants, the language in a security offering that requires creditors to meet certain measures of financial discipline. These covenants are unlike those found in other fixed-income securities. REIT debt investors also cite the presence of tangible assets on balance sheets and the relatively predictable nature of the firms' cash flows as other advantages relative to other corporate sectors.
Standing Out
Historically, unsecured REIT debt has found a devoted following among buy-and-hold investors, including institutions such as life insurance companies that purchase securities and hold them until maturity. In fact, more than 90 percent of the money invested in REIT bonds comes from life insurance firms, Perrein estimates.
The onset of the modern REIT era in the early 1990s marked the introduction of what has become known as the standard REIT covenant package, according to Kevin Riordan, a managing director with TIAA-CREF. These covenants emerged partly to ease investors' concerns about the risk associated with the "new" equity REITs coming to market.
Steven Schneider, a senior credit analyst with Principal Global Investors, says standard covenants require a REIT to: keep total debt to adjusted total assets at less than 60 percent; limit total secured debt to adjusted total assets to less than 40 percent; peg EBITDA to interest expense coverage of one and one-half times; and maintain an unencumbered asset to unsecured debt ratio of at least 150 percent.
The first three covenants are based on an incurrence test, meaning additional debt cannot be incurred if any of these covenants are violated, Schneider explains. The unencumbered asset to unsecured debt covenant is a maintenance test, "meaning it must be met at all times, not just when new debt is incurred," he adds.
REIT Unsecured
Debt Maturities
As of June 2004
($ in millions) |
| 2004 ......$1,834 |
| 2005 ......$5,217 |
| 2006 ......$3,596 |
| 2007 ......$8,837 |
| 2008 ......$6,839 |
| 2009 ......$7,649 |
| 2010 ......$3,869 |
| 2011 ......$7,230 |
| 2012 ......$5,900 |
| 2013 ......$6,721 |
| 2014 ......$4,385 |
Source:
Credit Suisse First Boston |
Collectively, the covenants impose strict financial discipline upon a REIT issuing publicly traded unsecured debt. With few exceptions, issuers today are still using the covenants that first appeared in the early 1990s.
"Some REITs might say the covenants are too conservative," and belong to an earlier time when REITs were perceived to be riskier than they are today, Riordan says. "But as an investor, we like them because they provide a number of different approaches to ensuring that the indebtedness will be repaid on a current and term basis."
Besides making certain a REIT's funds are sufficient to service debt obligations, the covenants ensure that a portion
of a REIT's assets are unencumbered by mortgage debt and available for sale or mortgage financing if the REIT should fall into financial distress. Certainly, firms in other corporate sectors have assets, but commercial real estate is regarded differently because of secondary markets for properties and also because, in most instances, REITs can sell properties without harming their core operations.
The unencumbered property portfolios ensured by debt covenants are a vital resource for REITs. "The flexibility it provides enhances the recovery prospects for unsecured bondholders," Schneider says. REIT covenants also promote stability in a firm's debt ratings, he adds.
Another factor that enhances the appeal of REIT bonds are the firms' cash flows. "REITs have an advantage relative to most other sectors as the contractual nature of its revenue streams provides predictability not found elsewhere," Perrein says. For example, sales revenue is the primary source of cash flow for some corporate issuers and this source may be highly volatile or subject to seasonal fluctuations in some industries.
That's not to say that REIT cash flows are completely insulated from the shocks of business downturns. Vacancies have climbed and rents have receded for the major property types during the past several quarters, straining operating income. Nonetheless, some REIT bond buyers regard the decline in property cash flows as minor.
"There has been little fluctuation in EBITDA, even with the dip in occupancies and weakening property fundamentals," says Brian Phillips, vice president of Travelers Life & Annuity.
In fact, REIT bonds resemble equities because the value of the respective securities has risen despite poor underlying business fundamentals. Dan Sullivan, a managing director with Wachovia Securities, notes REIT credit spreads—the difference between the yield on a risk-free investment such as U.S. Treasuries and the yield on REIT bonds investors demand—have tightened during the recent two years of weakening property performance. Tightening spreads imply lower yields and higher bond prices, as yields move inversely to prices.
"REITs were actually improving their credit fundamentals during this time by raising equity, selling assets and paying down debt," Sullivan says.
Headwinds and Tailwinds
The backing up of interest rates, changes in a widely used credit index and credit issues will each exert some pressure on REIT bond performance in the months ahead.
Higher interest rates are an anathema for fixed-income investors because they erode the value of their holdings. This may be less true for the buy-and-hold crowd, but rising interest rates are nonetheless meaningful to REIT bondholders.
The rate on the 10-year U.S. Treasury began to turn up in early April after the release of a favorable employment report for March. "If interest rates are rising on a good jobs number, that means office fundamentals will get better," argues Mark Streeter, CFA and vice president at J.P. Morgan Securities. "It means retail and industrial will do better and it means apartment fundamentals will get better as single-family homes becomes less affordable."
Improvement in the economy and property sectors will limit the magnitude of REIT credit spread widening even if interest rates are climbing, Schneider states. REIT credit spreads are also unlikely to widen greatly for two additional reasons.
First, trading volume in REIT debt is typically light, Streeter says, and light secondary trading of REIT paper would tend to support tighter spreads and, thus, higher bond prices. Secondly, Riordan of TIAA-CREF says that issuance of corporate bonds was down in the first quarter. "The issuance numbers are way down and there is not a lot of paper floating around," he says. "That will keep spreads tight."
Meanwhile, REIT bonds may face difficulty stemming from changes in the composition of a widely used credit index. The Lehman Credit Index is a proprietary index consisting of publicly issued U.S. corporate, foreign debentures and secured notes that meet specific maturity, liquidity and quality guidelines, according to a spokesperson with Lehman Brothers Inc. Starting in June, a bond issue must be at least $250 million to be listed in the index, up from $200 million. REIT bond offerings are usually smaller than the new limit.
"When a REIT goes to market, the deal tends to be from $100 million to $250 million," Perrein says. "A lot of investors will not come into the REIT sector because of a lack of liquidity; that is, the bonds don't fit in the Lehman Credit Index."
Streeter argues that index eligibility is important and REITs represented in indices such as the Lehman Credit Index will
benefit from broader coverage over the long term. "In times of distress, index eligible bonds may outperform due to better
perceived liquidity," he states.
Credit issues for REITs include financial stresses brought on by continued weakening of property fundamentals and specific company issues. The three major ratings agencies—Moody's Investors Service, Standard & Poor's and Fitch Ratings—are the fixed-income market's arbiters of risk and credit issues. While the firms employ consistent reasoning when rendering balanced assessments of REIT credit, commentary issued earlier this year by each firm highlight emerging issues that could result in rating actions for specific companies.
In its 2004 REIT Scorecard published in February, Fitch issued negative rating outlooks for the office and multifamily sector and stable outlooks for industrial, retail and health care. The outlook reflects general concern over weakness in property fundamentals.
Fitch included joint venture activity as an area it would monitor, suggesting that the contribution of properties by REITs to a joint venture could result in adverse selection for a REIT's core portfolio.
"To the extent that REITs are building assets for contribution to such ventures," the firm writes, "all development risk is incurred within the core portfolio, introducing earnings volatility and acting as a drag on core portfolio performance. As parties in interest to the core portfolio and not the ventures, unsecured lenders bear the brunt of the financing risk."
In its U.S. REIT and REOC Industry Study issued in February, Moody's wrote of a "broadly stable outlook for ratings of U.S. REITs, with negative trends in the office, multifamily and lodging sectors, which continue to experience operating pressures." John Kriz, Moody's managing director of real estate finance, adds that although all of the aforementioned sectors are continuing to experience operating pressures, a turnaround in multifamily and lodging has begun.
While the agency acknowledges REITs' strong financial discipline, easy to understand business platforms and good transparency, Moody's also expresses concern that the sector could pursue transactions utilizing risky financial structures to achieve greater earnings growth.
"One always worries about REITs throwing a Hail Mary pass," Kriz says. This concern could become evident in the use of more risky financial structures to complete property deals.
"In other words, when looking for earnings growth, the firm may be leveraging those assets more highly," Kriz says. The REIT may also have difficulty integrating those assets onto the balance sheet.
Standard & Poor's published its industry report card at the end of April. In the report, the agency comments, "most REITs ended 2003 having spent another year treading water and, in some cases, contracting modestly as they await signs of a clear recovery in fundamentals."
Lisa Sarajian, a managing director with S&P, acknowledges concern over joint venture arrangements. She is also concerned rising levels of secured debt and shifting corporate infrastructures "as these entrepreneurial entities become larger companies that need to be run differently."
These concerns notwithstanding, debate between the rating agencies and analysts on what the proper rating for the REIT sector should be lingers. Moody's rates the sector Baa, the lowest rung of investment grade. Most of the REITs in the S&P and Fitch rating universe carry a BBB rating, also at the low end of investment grade.
Kriz acknowledges that the possibility exists for REITs to move up the rating ladder. "But one needs to keep in mind that REITs are not cash-retention vehicles and, looking at firms from a fixed-income and credit point of view, a firm that does not have the ability to retain much cash is one that more likely will find itself in a stressed situation than one that has the ability to retain cash," he says.
But Streeter of J.P. Morgan argues that REIT bonds are under-rated compared to other corporates. "In our opinion, the low Baa opinion is too negative given the sector's bond covenants and exceptionally low default rate," Streeter says.
"Moody's says a mid-BBB universe of bonds over a 10-year period should default about 6 percent of the time," he adds. "In the past 10 years, we have had no equity REIT bond defaults. In the next 10 years, I expect we'll have none because when a REIT gets into distress, they end up tendering for bonds, going to the secured market and taking out bondholders."
The discussion continues amid the challenges faced by the REIT industry in the quarters ahead. While short-term outlooks on the REIT bond market may change, the long-term commitment of its dedicated investor base is obvious.
"REIT bonds offer very good yield on a risk-adjusted basis," maintains Phillips of Travelers. "They offer very strong returns and the potential for very strong asset recovery."
Art Gering is a regular contributor to Portfolio.
Bonds—REIT Bonds 