How Will REITs Fare?

By Dees Stribling

Across the board, recent events on Wall Street are turning heads of investors and REIT executives alike. With the Emergency Economic Stabilization Act of 2008 providing $700 billion in relief funds to institutions, the stock market yo-yoing and banks crumbling, where does real estate investment stand?

“The credit environment affects everyone in some way, but for the majority of REITs, the impact hasn’t been too adverse,” says Matthew Greenburger, an analyst with Citigroup Global Markets Inc. “It’s following the 80/20 rule: the 20 percent who are having issues get 80 percent of the attention. In the case of public REITs, the formula might even be more skewed—the 10 percent with troubles are getting 90 percent of the attention.”

How much leverage a REIT should employ has been a long-running debate in the industry, according to Michael Kirby, director of research at Green Street Advisors. “I believe it should be low over the long haul, because leverage doesn’t really get you anything on a risk-adjusted basis over the long run, but it sure can tie your hands during a credit crunch. The higher-leveraged REITs have underperformed pretty dramatically. It’s really come home to bite them.”

Silencing the Alarms

In the case of REITs, being conservative with leverage has typically meant that less than 50 percent of a balance sheet is leveraged, notes Kirby, though he's hesitant to call the current environment a "good" one for REITs or anyone else. "Everyone would prefer that capital flows freely," he says. "But relatively speaking, REITs haven't taken that much of a beating because of their conservative approach to borrowing."

The problems in the debt markets are constraining some REITs, agrees Glenn Mueller, real estate investment strategist of Dividend Capital Group, but most are weathering the situation. "A REIT that didn't do a good job with its finances is now suffering," he says. "But most REITs, even in the days when credit was easy, were conservative in terms of leverage. Most of them managed their loans so that they aren't suddenly due at a time when it's hard to refinance."

Various measures of REIT borrowing in recent years bear this out. According to SNL Financial LP, five years ago—in the third quarter of 2003—the average leverage ratio (total debt to total capitalization) for the approximately 115 REITs that the company tracked stood at 44.65 percent. That figure declined to a low of 36.65 percent in the fourth quarter of 2006, and then rose again into the mid-40s, only slightly above the average in the third quarter of 2003. As of the second quarter of 2008, REITs were, on average, only 44.84 percent leveraged with respect to total capitalization.

"Though they're higher, the more recent leverage ratios don't generally represent an increase in debt," says Keven Lindeman, director of the real estate group at SNL Financial. "It isn't more debt as much as lower stock prices, because the ratio will tick up as stock prices go down. So the ratio may be higher, but it isn't a cause for great concern."

When compared with total assets, debt levels are also a little higher, but not much. As of the second quarter of this year, REITs averaged 53.8 percent total debt to total assets. "It's just a fact of life for REITs," Lindeman says. "If their leverage goes too high, the rating agencies are going to punish them. So they've tended to be fairly conservative about debt, and at this moment, they're benefiting from it."

Corporate problems with debt, however, often involve short-term or variable-rate debt, and in that regard, REITs also have proven themselves fairly conservative in recent years. SNL Finanical notes that an average of 46.38 percent of REIT debt matures after 2012. Moreover, of all REIT debt, only 20.09 percent of it is variable-rate debt.

"Today's debt environment hurts everyone with debt coming due," says Peter Linneman, principal of Linneman Associates and a professor of finance at the Wharton School of Business. "To the extent that you have equity or long-term debt that's locked in, you're king. But even strong balance sheets are challenged today if that debt is maturing now."

An Advantage Goes to REITs

The majority of REITs that aren't highly leveraged may well be in a good position to ride out the current storm. However, many of them are positioned to more than merely survive, industry observers say. They might, in fact, be accruing a competitive advantage in the medium- or long-term, both in terms of accessing capital and asset acquisition.

"This environment gives REITs a relative advantage in financing," Kirby says. "REITs have access to more than one type of debt financing, either the secured mortgage market, or the unsecured market. The unsecured market hasn't always been hospitable this year, but there have been some very attractive unsecured offerings in the debt market recently, and that has given REITs quite a leg up. REITs have strength right now because they have more menu options than private players."

One of the more notable debt offerings by a REIT in 2008 came this spring with Simon Property Group's (NYSE: SPG) sale of $1.5 billion of senior notes. The offering consisted of $700 million of 5.3 percent notes due in 2013 and $800 million of 6.13 percent notes due 2018. "Because of its size and good financial health, Simon Property's something of a special case," Kirby says. "Its $1.5 billion debt issuance came at a really attractive interest rate, and also at a scale larger than most other REITs could manage."

For private real estate owners, notes Mueller, there are two essential sources of capital—private equity and private debt. "On the other hand, for REITs, there are really four sources—those two, plus public equity and public debt," he says.

From that standpoint, Mueller adds, "REITs have a ton of flexibility. It isn't always a good time to issue stock, but there's also the option of selling a 50 percent interest in a property or portfolio to an institutional investor. In that scenario, a REIT gets cash from the asset, half the profit and the management fee. If they can sell a joint venture interest with 6 percent yield, then take the return and invest it in a new development deal at 9 percent yield—why not do that?"

Steven Marks, managing director and REIT group head of Fitch Ratings, posits that REITs are also now at a competitive advantage as buyers. "The majority of the REITs that we rate are benefiting—somewhat—from the current environment, because other buyers are on the sidelines, particularly the ones who needed leverage to make their returns," he says. "Those buyers are out. Most equity REITs don't need to access the debt market in a significant way to finance acquisitions."

Lindeman agrees with that assessment. "On the whole, when real estate was going gangbusters, REITs had a hard time competing, because they couldn't be as aggressive as private players," he says. "Now some of the private players, such as Macklowe, are selling assets and raising expensive capital just to continue."

In the pre-crunch days, New York-based Macklowe Properties borrowed billions to buy a large piece of the former Equity Office Properties Trust portfolio. Macklowe has since had trouble refinancing that debt, forcing the recent sale of many of its newly bought assets. "It was hard for a REIT to complete with the likes of them back in the easy-money days," Lindeman says. "But that probably turned out to be a good thing for most REITs. Now they can ride out this current period and compete more effectively for assets."

The fact that they're in a stronger position than before to compete for assets doesn't mean that REITs are busy snapping up assets these days, however. "We haven't really seen an uptick in acquisitions, because there's still a bit of a disconnect between buyers and sellers," Lindeman says. "But for now, REITs are keeping their powder dry, hunkering down and focusing on running their portfolios and squeezing all the efficiencies that they can out of them."

That could change. "Many REITs will be able to access longer-term lines of credit to facilitate acquisitions in the coming year," Mueller says. "A lot of them already have those lines in place, representing hundreds of millions in purchasing power, or in the case of Simon Properties, over a billion dollars."

Problematic Debt

Though most REITs have faired reasonably well during the credit crunch, some have not. An example of debt debilitating a REIT is the Australian REIT Centro Property Group, which flew high once upon a time, becoming a major mall owner in the United States via leveraged acquisitions in 2006 and early 2007. The drying up of the commercial mortgage backed securities (CMBS) market later in 2007 cut off the company's main refinancing source. Share prices cratered, top management resigned and various assets are now being marketed—all with no assurance that the company will survive as an independent entity in the future.

Closer to home, Los Angeles-based Maguire Properties also gorged on acquisitions in the mid-2000s to add to its large stock of office properties in southern California. More recently, refinancing problems have obliged the company to divest itself of a number of these properties.

Another well-known example of a U.S. REIT caught in a vise of debt is Chicago-based General Growth Properties (NYSE: GGP), though its circumstances are hardly as dire as those of Centro. "Being big isn't necessarily an advantage for REITs, as evidenced by General Growth," Kirby says. "The company leveraged more than most REITs for its expansion before the credit crunch and the retail slump, and now it's a big company with some balance sheet issues."

All together, General Growth has to deal with about $18 billion in debt that's scheduled to come due over the next three and a half years. Because of that, the market hasn't been kind to the company lately, with its stock dropping about 47 percent in the year since September 2007. In August, president and COO Robert A.

Michaels was obliged to sell 700,000 of his shares in the company because of a margin call, and early this summer General Growth also announced the delay of a major mall project in Las Vegas.

Still, most observers expect the mall giant to be able to cope with its debt problems over the long run. "CMBS made it relatively easy for companies like General Growth to expand, and it was a problem when that tap shut off," says Fitch's Marks. "But in this case, they have other financing options—they just won't be as inexpensive, and the lenders are going to have more leverage."

Another segment of REITs that is struggling with debt more than the industry as a whole is mortgage REITs. Jumbo-mortgage specialist Thornburg Mortgage Inc. (NYSE: TMA) is a case in point. A recent report by Fitch noted that "default remain[s] a real possibility for Thornburg's corporate obligations, particularly if Thornburg becomes exposed to meaningful margin call risk."

According to Marks, much of the problem for mortgage REITs stems from that fact that they relied on the collaterized debt obligation (CDO) market for financing, and these days the CDO market is as dormant as the CMBS market. "They're financing assets using short-term lines of credit with margin requirements," he says. "A lot of commercial mortgage REITs have been subject to margin calls, and it's never a good thing when a lender picks up the phone and demands more money from you because the value of your assets have declined. A good many of the commercial mortgage REITs find themselves in that situation, and it's unclear how they're going to continue to grow and make acquisitions."