The extent to which a REIT uses debt efficiently is a key factor when investors analyze risk/reward tradeoffs. Debt used wisely increases returns and helps boost growth. Underutilize debt and a REIT will fail to maximize its returns and growth potential. Overutilize debt and a REIT
REIT Capital Preferences
To finance the purchase, construction or reconstruction of assets, REITs can turn to three sources of funds:
- Internally generated cash
The first source, cash, in unlikely, because REITs must distribute at least 90% of their income to unitholders. Only 10% of income, at most, remains to supplement retained earnings and cash. That leaves debt and equity as the two viable alternatives.
Raising Additional Equity Capital
In the case of closed-end equity REITs, raising cash through secondary offerings is problematic due to dilution. When REITs issue additional units, the result can be accretive or dilutive to unitholders, as measured by free funds from operations (FFO/unit). Naturally, FFO/unit declines when new units are issued. However, if the money raised by the offering can purchase properties with sufficiently high cap rates (i.e. rates of return), the offering is accretive. By “sufficiently high,” we mean that the cap-rate provided by assets purchased with funds from the new equity is high enough to overcome the dilution effect (that is, the decline in FFO/unit).
For example, suppose a REIT issues units at a price that implies a price/FFO ratio of 20. This requires a cap rate of (1/20), or 5%. Price/FFO ratios of 10 and 5 would require cap rates of 10% and 20% respectively. In effect, the more expensive the units, the lower the required cap rate and the more potentially accretive the issuance, because it is easier to acquire property at lower cap rates. The line of accretion is a curve plotted against Price/FFO (the X axis) and cap-rate (Y axis). Anything above the curve is accretive, whereas below the line is dilutive.
Issuing New Units
Thus, REIT management is bound to issue new units at a sufficiently high price that it avoids dilution. They can bleed out small batches of units through an at-the market (ATM) unit offering (in which units are issued at the current market price), or all at once with a normal offering at a set price per unit. ATMs are favored, since they have lower fees, but they are also less transparent, because investors don’t know when and how many new units will dribble out, and at what price.
Issuing new equity will of course alter the REITs debt/equity ratio, with one exception: The new common units can be used to retire preferred units of equal value, thereby leaving the D/E ratio unchanged. On the other hand, the new equity might be used retire debt, compounding the reduction to the D/E ratio and diluting the units already issued. For accretion to occur, the new equity capital must be invested in acquisitions that have a sufficiently high return (i.e., above the line of accretion).
When REITs issue debt, they assume that earnings will increase despite the additional interest expense. Of course, this might not hold true if a REIT faces liquidity problems and additional debt is needed to prevent bankruptcy. In such circumstance, the REIT might assume more debt, typically high-interest debt, to get it through a rough patch, and then repay it once conditions return to normal.
As of the end of 2018, REITs were primarily issuing fixed-rate, long-term debt with average maturities on debt outstanding rising to more than six years. In other words, REITs locked in low interest rates well into the 2020’s, protecting them from rising rates spurred on by the Fed as it continues to throttle inflation. The result is stronger balance sheets, which in turn makes it easier to raise money by issuing units.
Advantages of Debt Issuance
Since REITs are pass-through entities, they receive no tax advantage by issuing debt. Yet research indicates that REITs leverage ratios are about double those on non-REITs. The research further posits the following reasons for why REIT’s use debt:
- REITs own plenty of desirable tangible assets (i.e., real estate) to act as the collateral for borrowing.
- REITs bear the operating risk of volatile cash flows. REITs with highly volatile flows (and therefore volatile unit prices) would want to raise funding in a way that doesn’t exacerbate downside unit-price volatility. Issuing debt eliminates the new equity problems (e.g., dilution worries, loss of leverage, incorrectly valuing the negative reaction to new issuance announcements from existing unitholders, etc.).
- REITs tend to pursue leverage ratios that maximize risk-adjusted performance, whereas non-REITs target a leverage ratio that maximizes the corporation’s value. The research indicates a REIT’s ideal leverage ratio is 62.5% compared to 24.5% for non-REITs,
- Markets react more favorably to announcements of new debt than new equity.
Taken all together, the results indicate that REIT managers prefer to avoid the negative reaction to new equity issuance.
We understand that REITs should have a healthy appetite for debt. Nonetheless, the REIT leverage ratio of debt/assets (the debt ratio) has been dropping since the mortgage meltdown in 2009, and is now at all-time lows. This is true whether the assets are marked at book value or market value. Why no love for debt? Apparently, REITs fear overexposure to interest rates, which have been rising for a couple of years now. In a rising rate environment, REITs want to keep interest expense low enough to prevent damage to net operating income (NOI).
The debt ratio is defined as:
Debt Ratio = Total Debt / Total Assets
The debt ratio is the portion of REIT assets financed by debt. Total debt includes short- and long-term liabilities, but excludes certain liabilities, such as accounts payable and negative goodwill.
At the end of 2018 Q3, the average equity REIT had a debt ratio of 32.3%, meaning that assets outvalued debt by about 3:1, according to NAREIT.
Debt to Equity Ratio (D/E)
The debt-to-equity ratio is defined as:
Debt-to-Equity Ratio = Long-Term Debt / Unitholders’ Equity
At the end of 2018 Q3, the average REIT had a D/E ratio of 90%. One drawback with this metric is that the equity in the D/E ratio comes from the balance sheet, in which assets are valued at book rather than market value. Many of the properties in a REIT’s portfolio have appreciated above book value, thereby tending to undervalue equity and overstate the D/E ratio.
When comparing different REITs, understanding how to interpret their leverage ratios, and more importantly, how the ratios have evolved over time, provides a useful clue to how efficiently management is using debt to achieve its goals.