Wednesday, May 26, 2010

Elephant in the Room
I've read plenty of 10-Qs over the past few weeks.  I am beginning to think that many broker / dealers' and analysts' obsession with distribution coverage and Funds From Operations is too myopic.  Don't get me wrong, this is an important area, especially for the non-traded REITs raising significant amounts of investor capital based on high dividends.  Coverage ratios are convenient because they give a clear indication of REIT performance.   I feel that broker / dealers need to expand their analysis and start looking at maturing debt and how this could impact future cash flows.

I am concerned with non-traded REITs that have debt maturing over the next several years, and how these maturities will impact the REITs' balance sheets and future distributions.  I am not going to call out any particular REIT, but have put together the spreadsheet below based on composite data that I feel represents what could happen to a REIT as it goes to refinance its debt:

                                                        Original Purchase                   Refinance

Property Leverage 70% 60%
Cap Rate 6.50% 7.50%
Debt Interest Rate 3.50% 6.50%
Annual Debt Svc $1,225,000 $1,972,052

 Purchase Price / Value $50,000,000 $43,333,333 -13.33%
Leverage $35,000,000 $26,000,000
Original Equity $15,000,000 $15,000,000
Required Additional Equity - $9,000,000
Total Equity $15,000,000 $24,000,000
NOI $3,250,000 $3,250,000
Debt Svc $1,225,000 $1,972,052 60.98%
Net Cash Flow $2,025,000
$1,277,948 -36.89%
Cash Return On Equity 13.50% 5.32% -60.56%

The assumptions are that a property was acquired for $50 million.  I assumed 70% leverage, or $35 million and $15 million of equity.  I assumed the property was acquired at a 6.5% cap rate on net operating income of $3.25 million.  I assumed the original loan was interest-only and had variable rate interest at a rate of 3.5%.  This gave the property a cash return on equity of 13.5%. 

Now this hypothetical property has to refinance this favorable debt.  In my refinance assumption I kept the NOI the same.   Cap rates have increased and leverage ratios have dropped over the past two years.  I used a new valuation cap rate of 7.5% and a 60% leverage ratio.  The property is now valued at $43.3 million (using a 7.5% cap rate on the unchanged NOI), and the amount of a new loan is only $26 million (60% leverage on the new $43.3 million value).  This leaves a $9 million shortfall that the REIT needs to retire the original loan.  So, the original $15 million of equity needs to be increased to $24 million.  Looked at another way, the REIT needs to add an additional $9 million to a property that has lost $6.7 million of value.  I assumed the new loan has a rate of 6.5% and amortizes on a thirty-year schedule.

The end result is that the debt service increases, despite the lower leverage, and the cash flow decreases.  In the example above, the return on equity drops to 5.3%.  The other option is to walk away from the property, but this has its downside, too.  How can a sponsor justify walking away from property with positive operations?

Non-traded REITs that are raising capital may be able to pay down original debt.  REITs that are not raising capital may have to cut distributions to preserve cash to repay debt.  The end result may be long-term lower cash flow, as shown above.

This scenario can get worse if it is expanded to lease renewals.  Lower lease rates would lead to a lower NOI, which leads to a lower valuation, which leads to lower refinance debt amounts, which leads to more REIT cash to repay the exisitng loan, which leads to lower returns on equity.  You get the picture. 

It is not a bold statement to say that REITs struggling to cover their current distributions, and that have significant debt maturing over the next few years, will be hard pressed to maintain their current dividends.  Analysts and broker / dealers need to turn their attention to non-traded REITs maturing debt and be aware of the potential impact on cash levels and distributions.

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