09/30/2019 | by

With core, high-grade REIT bond issuance through August already ahead of last year’s total, J.P. Morgan’s Mark Streeter sees a healthy capital markets environment for REITs today. More debt issuance on the long end is likely given lower rates. Importantly, most rated REITs have a zero default record over a 25 year period. At the same time, most REITs have leverage ratios that should prove more than adequate in the event of an economic downturn.

REITs have extended their debt maturities to the longest period on record. Will they continue to do so?

Yes, we expect more REITs to issue 30-year bonds. Insurance company demand remains very strong and with lower rates, we do expect REITs to more actively consider issuing on the long end as the all-in cost has come down.

Are current REIT debt-to-EBITDA leverage ratios low enough to continue to stimulate growth?

It comes back to access to capital, ratings, and maintaining enough dry powder for the next crisis, recession, or general slowdown in growth. Most REITs target mid-to-high BBB ratings, which in most property sectors equates to six times debt/EBITDA leverage; or to put it another way, debt/assets at book leverage of less than 40%. We think this provides more than enough cushion in the event conditions deteriorate.

Keep in mind that most rated REITs issue with a battle-tested set of bond. At the extreme, asset values would have to fall by more than a third before bondholders would be impaired absent any self-help. This is the main reason why equity REITs with these covenants have a 0.0% 25-year bond default track record.

Has this strategy given them much more “dry powder” for future growth?

We would argue that REIT leverage ratios are too low for current ratings, so yes, many REITs have ample “dry powder” where they sit today. The question is whether or not REIT management teams want to push for higher ratings—which are deserved in our opinion, or alternatively, tap into today’s excess debt capacity. 

Many REITs have relied more on unsecured funding rather than secured for their debt in recent years. How has this impacted their flexibility?

Most REITs have plenty of secured debt capacity. Unsecured funding for BBB or higher rated REITs is quicker, easier, more flexible, and quite often cheaper than secured alternatives. The huge unencumbered asset pools that most rated REITs maintain are the safety blanket for the next crisis where bond market access may be temporarily shut down or becomes prohibitively expensive.

At-the-market (ATM) issuance now accounts for over one-quarter of common equity raised by REITs. What are the pros and cons of an ATM program?

From a credit perspective, we love to see equity in all forms. ATMs help REITs match fund equity to acquisitions, thereby avoiding the timing dilution larger equity deals can create. The downside is that active use sops up stock liquidity and is a turn-off to some investors that prefer catalyst-driven stock price action.  

How does short-term debt fit into funding a long-term property portfolio and liquidity needs?

We tend to agree with the ratings agencies and think it’s fine in moderation for REITs with a demonstrated track record of strong financial stewardship to tap into the commercial paper market, but it’s not for everyone. There are six commercial paper programs in place today for REITs in the major property segments, which are all relatively modest in size when measured against the full revolver capacity each of these REITs maintain. One major concern is that long-term assets should be financed with long-term debt, which is why these programs should be used modestly and REITs should extend maturities as long as possible when market conditions allow.

Another point that resonates with us is that consumer paper programs are market sensitive and fickle. For example, if there is a sudden lack of access to consumer paper, even if these programs are “covered” by bank line capacity, it could exacerbate the already negative market perception that some investors have that REITs are extremely vulnerable to capital markets dislocations due to the lack of retained cash flow given the 90% payout rule.

Is there a flip side to this risk?

Once a REIT commits to a consumer paper program, management is effectively doubling down on the commitment to the proper ratings to support the program; in most cases, a high BBB minimum. So, yes, there are risks if REIT CFOs pursue commercial paper programs. In spite of that, the savings from these programs, often about 50 basis points, are meaningful and the sector remains under-rated with a near perfect default track record. We doubt the wider adoption of consumer paper programs will materially change bond investor appetite for this sector.

Have recent interest rate cuts changed your outlook in any way?

REITs, and commercial real estate in general, have historically been viewed as an inflation hedge—higher inflation leads to higher rents. However, lower interest rates are generally favorable for REIT securities in the short term. The obvious lower cost of funding is important for a sector with approximately six times debt/EBITDA leverage on average. Retained cash flow for most REITs is modest at best, so lower rates along with open capital markets support the sector’s voracious appetite for capital. REIT stocks have demonstrated a strong negative correlation (at least over the short term) to a declining or low rate environment (lower rates mean higher REIT stock prices) as the bid for dividend paying stock is stronger when rates are low.

What risks do you see for a recession, and what should real estate investors watch for?

The JPMorgan recession risk indicator at 43.5% implies that a recession is certainly possible. Furthermore, the inverted 2s-10s Treasury curve has consistently signaled a recession within two years from the occurrence.

Nevertheless, the combination of the president leaning on the Federal Reserve, relatively strong U.S. economic indicators, trade uncertainty, the election cycle, and several other factors make it very difficult to predict the future.

Therefore, we applaud those REIT managements who are exercising caution. As much as we think REITs maintain significant leverage capacity relative to current ratings, a prudent approach to balance sheet management is warranted in this environment.

Mark Streeter’s 25-year career in real estate finance tracks the rise of REITs as an asset class. He is managing director and senior publishing sell side analyst in North America credit research at J.P. Morgan, with responsibility for high grade and high yield coverage of the REIT and transportation sectors.