Excerpts from this article appeared in the December 2019 edition of the Forbes Real Estate Investor.
Ever since the last recession, real estate investment trusts’ (REITs) leverage ratios have been on the decline. That’s something we like to see.
It’s not optimal to make the kind of mistakes we saw in painfully clear light as the housing market burst back then. But at least the majority of these companies learned their lessons. They’ve put prudent balance sheet management at the top of their priority’s list – reducing the overall sector’s exposure to interest rates in the process.
Many have taken steps to strengthen their balance sheets, with much of the focus centered on recalibrating levels of leverage. As a result, those ratios (measured as the ratio of debt to total assets) are now below pre-financial crisis levels.
In fact, according to industry expert Nareit, they’re at the lowest level on record!
With that in mind, I made sure to sit down with credit expert Stephen Boyd. A senior director at Fitch Ratings’ Corporates group, he began there in 2012 and became the REIT sector head in 2018.
Before joining Fitch, Stephen was a vice president and equity research analyst in the REIT group at Cowen and Company, where he focused on office, industrial, and hotel properties especially. And before that, he was an equity research analyst at several investment management firms, including Polen Capital Management and Osprey Partners Investment Management.
Stephen earned a B.A. in business administration from the College of Charleston and an M.S. in real estate at New York University’s Schack Institute of Real Estate. He was awarded the Chartered Financial Analyst designation in 2003.
For those reasons, and many more, he’s definitely one to talk to about the sector’s health and where it’s headed. I hope you get as much out of it as I did.
REITs in Recessions Past and Future
Brad Thomas: How do you feel with regard to the REIT credit environment now, relative to the end of the last recession?
Stephen Boyd: REIT credit profiles are arguably the strongest they have been since the modern REIT era began in the early 1990s. Most REITs have adopted more conservative financial policies during this upcycle, partly informed by experiences during the great financial crisis.
The market has generally awarded higher valuation multiples and share prices to REITs that have adopted lower financial policy leverage targets, aligning the interests of debt and equity investors and suggesting that the more conservative financial policies will sustain through the cycle.
Thomas: Do you feel as though REITs have prepared their balance sheets adequately in terms of getting ready for the next recession?
Boyd: REITs have strengthened the left-hand side of the balance sheet in several key ways. Many REITs have undertaken extensive portfolio repositioning programs to reduce and eliminate slower-growing and/or capital-intensive assets in secondary and tertiary markets. Development platforms are more conservatively sized relative to the prior cycle, including lower total estimated investment values and unfunded components relative to gross assets.
Most REIT sectors have reduced their exposure to JV [joint venture] ownership, which Fitch views as a form of subordination that limits operational and financial flexibility. REIT liability profiles are also stronger given lower levels of secured debt and longer weighted average maturities.
Alternatively, floating rate debt as a percentage of total debt has grown from 16% to 21% during the last 10 years. This is somewhat counter intuitive given the availability of attractively priced long-term unsecured debt capital. Bank term loans, revolver borrowings, to a lesser extent, CP issuance have contributed to the rise in variable rate debt.
Thomas: I recently attended REITWorld, WHERE I overheard a respected money manager saying that REITs should increase leverage. What are your thoughts on that topic?
Boyd: Fitch’s ratings are forward-looking credit opinions that describe probability of default and recoveries under a default scenario. Generally speaking, default probability and leverage are positively correlated. However, Fitch does not provide advice.
Said differently, it is up to every issuer to determine what financial policy targets and ratings levels best achieve the company’s objectives. Nevertheless, I have seen compelling empirical research and anecdotal evidence suggesting that lower-levered REITs outperform over longer time periods. I can’t say the same for higher-levered REITs.
Thomas: Last year, Realty Income (O) achieved an A-rating from S&P. What does your team look for when considering the upgrade to an A rating?
Along those same lines, S&P has Kimco (KIM) and Ventas (VTR) rated BBB+. So I’m curious as to whether these cyclical sectors (retail and healthcare) weigh on the company’s credit metrics?
Boyd: The A category is rarefied air for U.S. corporates generally and equity REITs specifically. Fitch expects issuers to possess a cushion against not just foreseeable, but increasingly unforeseen operational or financial events as credit profiles move up the ratings curve.
For corporate issuers, this generally includes having demonstrably greater financial and operational flexibility through downside and stress scenarios. REIT credit profiles are somewhat at odds with the latter given the inherent cash retention constraints of the REIT tax election and related need for consistent access to external capital sources to refinance debt maturities.
Fitch rates a handful of REITs in the A category. The common thread running through most includes superior asset quality, elite capital access (including public bonds and through-the-cycle secured mortgage debt access), and appropriately conservative financial policies.
Fitch rates the three issuers mentioned BBB+, primarily due to views on asset quality and/or secured mortgage availability that fall short of A-category rated peers.
Thomas: How do preferred issuances weigh into your credit reporting model? In other words, how do you analyze preferred shares? And do you consider them debt in your underwriting?
Boyd: Most REIT preferred qualify for 50% equity treatment under Fitch’s hybrids criteria. However, we principally focus on net leverage (i.e., net debt to recurring operating [earnings before interest, taxes, depreciation, and amortization] EBITDA) excluding preferreds when setting rating sensitivities for REITs.
We believe a maturity of “never” is positive for REIT credit profiles – particularly given the inherent cash retention constraints of the REIT tax election. Fitch primarily considers preferred equity in our calculation of fixed charge coverage.
Thomas: Finally, what’s your view on the prison and gaming sectors? As you know, these subsectors are more volatile and I’m curious as to how you analyze these companies in context of their credit quality.
Boyd: Fitch generally requires more conservative credit metrics for REITs with specialty property types given the weaker secured mortgage debt availability relative to traditional property formats. Prisons and gaming REITs fall into the specialty category.
Earlier this year, Fitch downgraded prison REIT CoreCivic (CXW) to BB from BB+ and assigned a Negative Rating Outlook following announcements by large money centers and regional U.S. banks that they would exit lending to private prison operators.
I own shares in CXW, O, KIM, VTR