Fitch: REIT 30-Year Issuance A Net Credit Positive
NEW YORK -- July 2, 2014
Liquidity benefits derived from 30-year issuance, combined with the enhanced
visibility of interest costs as interest rates remain near historical lows,
are generally viewed as a credit positive, according to Fitch Ratings. These
positive elements are balanced by an increase in the asset/liability duration
mismatch and the "unknown unknowns" that could arise from saddling the next
generation of management with current REIT covenants.
Over the last nine months, two U.S. REITs have issued 30-year unsecured bonds.
In June, Equity Residential Inc. sold $750 million of senior unsecured notes
due in 2044 at a 115 bp spread to the benchmark Treasury rate. Last September,
Ventas Inc. issued $300 million of 5.70% senior unsecured notes due 2043 at a
195 bp spread to the benchmark rate.
Issuing 30-year debt improves a REIT's debt maturity ladder by reducing the
percentage of debt maturing over the rating horizon (typically three to five
years), assuming constant leverage. Fitch views term (maturity), rather than
payment, as the principal risk to REIT credits given the constraints on cash
flow retention inherent in the REIT model, viewed against generally stable
cash flows for most REITs, which often benefit from long-term leases to
Long-duration, fixed-rate debt also improves a REIT's interest-cost
visibility. Interest is typically the largest recurring cost for REITs,
somewhat analogous to cost of goods sold for traditional corporate industrial
issuers. Improved visibility on a significant component of a REIT's cost
structure should aid in its ability to plan and execute its strategy.
However, 30-year maturities extend well beyond even the longest lease terms
for REIT assets, save for select retail anchor-tenant leases with extension
options. Issuing such long-term debt can increase the duration gap between a
REIT's assets (defined as weighted average lease term) and its liabilities
(weighted average maturity), potentially exposing a REIT to greater cash flow
volatility based on changes in inflation and interest and rental rates. This
duration mismatch can be particularly acute for short-duration property types,
such as hotels, apartments, self-storage and industrial, which generally have
shorter weighted-average lease terms ranging between nightly for hotels and
three to five years for industrial.
A deflationary U.S. economic scenario would likely pressure rental rates and
REIT cash flows. Managing balance sheets to a narrower duration gap would
allow for a repricing of a REIT's liabilities to help offset the decline in
cash flows under such a scenario. Prepayment or "make whole" penalties would
likely make retiring a 30-year bond ahead of maturity prohibitively expensive.
Burdening the future generation of a REIT's management with current covenants
could cause unforeseen consequences. Items such as operating strategies and
accounting definitions can change over time, perhaps in ways not contemplated
by existing covenants. Some of the first REIT unsecured bond indentures in the
early 1990s failed to consider that accounting definitions can change,
resulting in expensive consent solicitations for some REITs to adjust EBITDA
definitions to exclude noncash charges, as one example. Certainly the
flexibility has improved as REIT bond indentures have evolved. Nevertheless,
even the most thoughtfully written indentures today could cause unintended
consequences down the road.
Some forms of long-term financing obligations are more desirable than others.
For example, Fitch views the so-called 30-year "baby bonds" issued by Ventas
favorably due to the imbedded call optionality after a five-year period.
Fitch also treats REIT preferred stock as 100% equity for leverage purposes
given the perpetual nature of the obligations and the inability of dividend
nonpayment to trigger corporate default. Perpetual capital is clearly
advantageous in the context of REIT tax regulations that limit the ability for
REITs to retain internally generated cash flows, which requires REITs to have
consistent access to the capital to satisfy debt maturities. We also view the
standard five-year call optionality imbedded in REIT preferreds as an
attractive risk mitigant in case interest rates unexpectedly decline from
current low levels.
The above article originally appeared as a post on the Fitch Wire credit
market commentary page. The original article can be accessed at
www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
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Stephen Boyd, CFA
+1 212 908-9153
+1 212 908-9123
Fitch Ratings, Inc.
33 Whitehall Street
New York, NY 10004
Sandro Scenga, +1 212-908-0278
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