It is very important for an investor to understand the balance sheet and financing strategy of a REIT. REITs, more than any other business, are at the mercy of capital markets and unit holders for their funding needs. REITs that don’t get this right won’t be around for long.
Unlike the investor of a typical company who needs to understand the working capital requirements of the company and the value of its intangible assets such as goodwill, a REIT investor has different concerns. Below are the key areas one should look at when analysing a REIT’s financial strategy. All this information is available in the quarterly financial statements.
1. Overall leverage. Dividing the total debt (including deferred payment in units or cash) by total assets gives the leverage of the REIT. As per the Monetary Authority of Singapore (MAS) rules, it should be less than 35% if the REIT is not rated by a major credit rating agency, and not more than 60% in any case. The REIT’s leverage should, however, be seen in the context of its business. What is high leverage for one REIT might not be for another. Usually, retail REITs have the highest gearing as strong long-term mall leases and high occupancies offer them more stability compared with a hospitality REIT where the cash flow is more volatile. Banks also are reluctant to finance REITs with overseas properties; this is one of the reasons why REITs with overseas properties such as Lippo-Mapletree and SaizenREIT have much lower gearing. Leverage levels also have an impact on valuations as high leverage is likely to lead to capital calls and low leverage indicates more room for acquisitions.
2. Debt repayment schedule. REITs have to constantly refinance their debt as their loans are not amortised. If a large portion of debt repayments falls due during the same time, there is a refinancing risk due to the volatile nature of capital markets. A prudent REIT will have staggered debt maturity to minimise refinancing risk.
3. All-in interest cost. REITs with higher credit ratings, a strong portfolio of assets and a blue-chip sponsor have lower financing costs. Financing costs also depend on the sources of financing. Bank loans traditionally are the cheapest but that is now changing with some of the larger REITs such as CMT raising loans on good terms from the capital markets.
Since the financial crisis of 2008–2009, interest rates have been very low and quite stable
but this is unlikely to continue forever. As interest rates rise, investors will need to factor in the increased refinancing costs for debt raised at low levels. Watch out for REITs that have maturing debt at much lower than market rates. Once the debt is refinanced, the interest expenses will increase. When comparing interest costs among different REITs, make sure the loans are denominated in the same currency.
4. Unencumbered assets. When banks give loans, they like to have collateral to fall back on in case the borrower runs into financial difficulties. Having unencumbered properties (properties that are not mortgaged to any lender) gives a REIT more financial flexibility during times of weak credit markets. It can quickly pledge the properties to a bank to get a loan or, in a worst case scenario, even sell the property to service its debt.
5. Sources of financing. This is a critical area not accorded due importance by investors. A REIT with a variety of funding alternatives will be better placed to thrive in different types of market environment. Let us look a bit deeper into the different types of financing available to REITs:
a. Bank loans. This is the most basic type of financing and can range from a one-year bridging loan to a long-term loan. These loans can be secured with the REIT’s property/properties (similar to an individual getting a housing loan by mortgaging his property) or unsecured. Banks also extend committed lines of credit to credit-worthy customers, for which they charge a fee. The riskier the loan, the higher the interest rate that is charged. Banks impose loan covenants that allows them to call back loans if certain conditions are not met, such as leverage ratios increasing above a certain level or the REIT manager reducing ownership beyond a certain level. The REIT investor can easily compare the loan rates of various REITs during various times and see the difference that a strong sponsor and a high-quality portfolio of properties make when procuring funding from banks. Irrespective of the number of funding sources, it is critical for REITs to have good relationships with several banks that can lend in bad times.
b. CMBS (commercial mortgage-based securities). This is a form of financing where the loans originated by banks are securitised and sold to investors. This enables even investment banks to originate loans as they are sold off to investors and the capital received enables them to originate new loans and so on. CMBS was widely used by the REITs before the financial crisis hit in 2008. Since then, this market has been quite low-key and is unlikely to play a major role in REIT financing in the near future.
c. MTN (medium-term note). This is a popular source of financing with many REITs. An MTN programme is established with a bank that, for a fee, will undertake to raise financing from the capital markets, usually institutions and high net worth
individuals, on a “best efforts” basis rather than underwritten by the banks (“underwritten” means that the banks take the risk of providing financing should there be no demand for the credit from investors). This form of financing allows a REIT to tailor its debt issuance to meet its financing needs either continuously or intermittently.
Under this programme, it can take advantage of a favourable market environment (low interest rates, high credit appetite) to raise capital quickly and need not raise all funds at once as in the case of a bond.
d. Bonds and perpetual securities. The local currency bond market is still in a developing stage in Asia. Since 2010 however, the SGD bond market has been increasing in popularity as an alternative funding source although the depth of this market remains lower than that of the traditional USD bond market. REITs are also getting more creative in their sources of financing. In February 2011, CMT issued two-year retail bonds to raise S$300 million SGD bonds at an interest rate of 2% per annum. The minimum investment sum was as low as S$2,000 which allowed the retail investor to participate for the first time. This was a creative move as it tapped into the huge amount of cash that was earning very low interest rates in bank deposits. Tapping retail savings opens up another source of funding for REITs that have a high-quality credit profile. In February 2012, Mapletree Logistics Trust even issued perpetual bonds at 5.25% interest rate, becoming the first REIT to issue such a security.
e. Convertible bonds. Convertible bonds allow the holder of the bond to convert them to equity at a certain conversion price. In return for this option, the interest rate paid is usually less than that for a regular bond. This mode of financing is more popular during strong markets and can be tailored to suit a REIT’s acquisition strategy. Consider the acquisition of the Atrium@Orchard by CMT. Acquired at a yield of just 2.1%, the acquisition could not have been accretive even if fully funded with debt as the cost of debt through a bank loan or a regular bond would have been at least 3%. Convertible bonds came to the rescue with a coupon of just 1% for five years because of the conversion option at a reasonable 25% premium over the then prevailing price (May 2008). Given CMT’s excellent historical performance and blue-chip pedigree, the buyers of the bond probably thought that it could appreciate enough for the conversion option to be profitable. This was before the Lehman collapse in September 2008 when the credit markets were still fairly stable. The coupon was 1% but the yield to maturity of the bond was 2.75% as the convertible bonds were to be redeemed at 109.31% of the principal value at the end of the five-year tenure. (There was also an option to redeem at 105% of the principal value at the end of three years.) This fit in well with CMT’s strategy of working their magic on The Atrium@Orchard such that the rental yield by the time of redemption would be higher than the yield to maturity and the acquisition could become truly yield-accretive.
f. Preferred and convertible preferred units. What if a REIT wants to make an
acquisition but does not want to increase leverage further and also does not want to dilute existing unit holders’ equity immediately? The answer is to issue preferred stock which is carried on the REIT’s books as equity and not debt. These units carry a dividend just like common stock but they rank higher in the pecking order should there be a default. Unlike common stockholders, the holders do not participate in capital gains and have to be content with their dividends forever as they are usually not redeemable by the holder (they can be redeemed by the issuer though). Another variation on this is the one used by Starhill Global REIT in 2009 when it acquired assets in Malaysia and Australia. They issued CPUs (convertible preferred units) whose holders received a set dividend yield which had to be converted into regular units by the seventh year at a set price. The idea was that by then the rental gains would have offset the dilution impact of the converted units.
g. Placement and rights issues. A very straightforward method of raising cash is to just issue new equity. If it is done to third party investors, it is called a placement and if it is offered to its shareholders, it is called rights. The problem with this method is that it is usually the most expensive especially if a REIT trades at high trading yields.
Placements are normally done when the overall quantum to be raised is not high and can be quickly placed out to a few institutional investors. A rights issue on the other hand involves a lot of work and is not worth the effort for small sums.
In summary, the balance sheet and financing strategy of a REIT is critical to its long-term survival. The good REITs show a disciplined and well-thought through strategy in managing their financing. They are not unduly leveraged and show the ability to raise financing from a variety of sources at competitive rates. They have their debt maturities well-spaced out to avoid refinancing shocks.
Here is a list of key questions regarding a REIT’s financing strategy an investor should probe into:
• What leverage levels and interest coverage ratio has the REIT maintained historically?
• What are the different sources of financing used by the REIT?
• What percentage of its properties is unencumbered?
• Does the REIT frequently rely on short-term (less than three years) bank loans for financing acquisitions?
• Does it frequently call on existing unit holders for capital or make private placements to refinance existing debt?
• Does the REIT have a meaningful MTN programme? What interest rates has it been able to achieve for the different sizes and tenures of notes issued?
• Are its debt maturities well-spaced out?
• Does it refinance its obligations early and raise funds during good times rather than wait till the last minute?