Big Boy Pants
I have noticed over the past year or more that non-traded REITs are getting sophisticated in their financing, credit crisis notwithstanding.  Just last week it was announced that Wells REIT II raised $250 million in a bond offering (5.875% interest for seven years) and CNL Lifestyle REIT raised $400 million in a bond offering (7.25% interest for eight years).  The Wells REIT II bond offering is a rated bond, which is why its interest is lower than the rate on the CNL Lifestyle bond.  I am not aware of any non-traded REIT that had issued bonds before last week.

Last month this blog noted Health Care Trust of America's line of credit and its strict controls on distributions.  Other non-traded REITs are also obtaining lines of credits to facilitate acquiring properites and in some cases to help pay distributions.  (For without distributions, the REITs don't get equity flows, which means they won't be able to repay their lines of credit.  "We must borrow money to pay distributions, so we can raise money to repay the debt."  A classic Catch-22 if there ever was one!)

I understand that the lines of credit are being used to smooth cash flows and to facilitate acquisitions in advance of equity.  The Wells and CNL bond issues are a sign of maturity and may benefit these REITs in the long run by exposing them to the capital markets before their listings (although I am still trying to figure out how CNL Lifestyle benefits from a 7.25% interest rate).  The non-traded REITS are entering into sophisticated transactions that contain strict financial restrictions and require the REITs to operate within the debt covenants.  As an example of the level of complexity, the following passage is from CNL Lifestyle's indenture for its recent bond offering and details the restrictions, in mind-numbing legalese, on Lifestyle's distributions:

Section 4.07 Restricted Payments.

(a) The Company will not, and will not permit any of its Restricted Subsidiaries to, directly or indirectly:

(1) declare or pay any dividend or make any other payment or distribution on account of the Company’s or any of its Restricted Subsidiaries’ Equity Interests (including, without limitation, any payment in connection with any merger or consolidation involving the Company or any of its Restricted Subsidiaries) or to the direct or indirect holders of the Company’s or any of its Restricted Subsidiaries’ Equity Interests in their capacity as such (other than dividends or distributions payable in Equity Interests (other than Disqualified Stock) of the Company and other than dividends or distributions payable to the Company or a Restricted Subsidiary of the Company);

(2) purchase, redeem or otherwise acquire or retire for value (including, without limitation, in connection with any merger or consolidation involving the Company) any Equity Interests of the Company or any direct or indirect parent of the Company;

(3) make any payment on or with respect to, or purchase, redeem, defease or otherwise acquire or retire for value any Indebtedness of the Company or any Guarantor that is contractually subordinated to the Notes or to any Note Guarantee (excluding any intercompany Indebtedness between or among the Company and any of its Restricted Subsidiaries), except a payment of interest or principal at the Stated Maturity thereof; or

(4) make any Restricted Investment (all such payments and other actions set forth in these clauses (1) through (4) above being collectively referred to as “Restricted Payments”),

unless, at the time of and after giving effect to such Restricted Payment:

(1) no Default or Event of Default has occurred and is continuing or would occur as a consequence of such Restricted Payment;

(2) the Company would, at the time of such Restricted Payment and after giving pro forma effect thereto as if such Restricted Payment had been made at the beginning of the applicable four-quarter period, have been permitted to incur at least $1.00 of additional Indebtedness pursuant to the tests set forth in Section 4.09(a), 4.09(b) and 4.09(c) hereof; and

(3) such Restricted Payment, together with the aggregate amount of all other Restricted Payments made by the Company and its Restricted Subsidiaries since the date of this Indenture (excluding Restricted Payments permitted by clauses (2), (3), (4), (5), (6), (7), (8) and (9) of paragraph (b) of this Section 4.07), is less than the sum, without duplication, of:

(A) 95% of Funds From Operations of the Company for the period (taken as one accounting period) from January 1, 2011 to the end of the Company’s most recently ended fiscal quarter for which internal financial statements are available at the time of such Restricted Payment (or, if such Funds From Operations for such period is a deficit, less 100% of such deficit); plus

(B) 100% of the aggregate net cash proceeds received by the Company since the date of this Indenture as a contribution to its common equity capital or from the issue or sale of Qualifying Equity Interests of the Company or from an issuance of Qualifying Equity Interests of the Company pursuant to the DRP (it being understood that for the purposes of this clause (3)(B), with respect to any issuance pursuant to the DRP, the Company will be deemed to receive net cash proceeds equal to the amount of the cash dividend they otherwise would have paid in respect of such Equity Interests) or from the issue or sale of convertible or exchangeable Disqualified Stock of the Company or convertible or exchangeable debt securities of the Company, in each case that have been converted into or exchanged for Qualifying Equity Interests of the Company (other than Qualifying Equity Interests and convertible or exchangeable Disqualified Stock or debt securities sold to a Subsidiary of the Company); plus

(C) to the extent that any Restricted Investment that was made after the date of this Indenture is (a) sold for cash or otherwise cancelled, liquidated or repaid for cash, or (b) made in an entity that subsequently becomes a Restricted Subsidiary of the Company, the initial amount of such Restricted Investment (or, if less, the amount of cash received upon repayment or sale); plus

(D) to the extent that any Unrestricted Subsidiary of the Company designated as such after the date of this Indenture is redesignated as a Restricted Subsidiary after the date of this Indenture, the lesser of (i) the Fair Market Value of the Company’s Restricted Investment in such Subsidiary as of the date of such redesignation or (ii) such Fair Market Value as of the date on which such Subsidiary was originally designated as an Unrestricted Subsidiary after the date of this Indenture.

Notwithstanding the foregoing, the Company and any of its Restricted Subsidiaries may declare or pay any dividend or make any distribution or take other action (that would have otherwise been a Restricted Payment) that is necessary to maintain the Company’s status as a real estate investment trust under the Internal Revenue Code if (i) the aggregate principal amount of all outstanding Indebtedness of the Company and its Restricted Subsidiaries on a consolidated basis at such time is less than 60% of Adjusted Total Assets and (ii) no Default or Event of Default shall have occurred and be continuing.

This is a very complex agreement, with repeated references to defined terms located elsewhere in the indenture.  It's a document written by lawyers for lawyers.  The way my non-lawyer eyes read the above clause is that Lifestyle can continue paying its current distribution rate to investors, but if Lifestyle's leverage exceeds 60% of assets, than the restrictions kick-in.  The REIT's leverage was at 55% of assets at year-end 2010.

The point is not the above legal jungle, but that this jungle is complex and the once financially staid world of non-traded REITs has embraced a treacherous path.  I don't believe that REITs accessing sophisticated financing is bad, actually I think it's good.  Interest rates are still near historic lows and it makes sense to take advantage of the low rates, if done in a prudent manner.  But the REITs need to understand that the banks are not their friends.  These lines of credits and bonds have restrictive covenants that REIT managers (as well as the broker / dealers that sell these non-traded REITs) need to read and understand.  Investors, too, need easy-to-understand disclosure - i.e. "if our leverage ratio (amount of debt divided by total assets) exceeds 60%, we will have to cut the distribution we pay you."  Banks will pounce if the covenants are not obeyed and ignorance is not a defense.   Banks do not come out on the short end of too many deals.

The low interest rates on the lines of credit are enticing, and make acquisitions more attractive.  But buying a long-term asset with short-term debt that provides accentuated returns is seductive, but unsustainable.  I am seeing lines of credit being used to repay maturing debt.  Retiring debt with a line of credit without a plan to replace the line of credit with either equity of permanent mortgage debt is reckless.  If REIT advisors don't act to quickly match property debt with the property's expected hold period, the REITs could be caught in a squeeze if interest rates rise, or if equity raises fail to match short-term debt maturities.  I suspect I'll be writing multiple posts about debt covenants in the future.