REITs and Debt – A Surprising Partnership
You do not need debt in your life. It may be convenient at times (like a credit card or home mortgage,) but if you had to, you could get by on a cash basis. Many people have actually chosen to go debt free to avoid the problems associated with debt. A REIT does not have this option. In order to grow in a normative fashion, a REIT must take on debt. The “why” behind this is important, and it will have ramifications for evaluating a REIT balance sheet.
Why REITs Must Take on Debt
REITS must take on debt for a very simple reason. If they don’t, they won’t have any funds to grow the business. If you started a private business, you could take the profits and reinvest them back into the business. The laws regulating REITs don’t give them this option. They are required to pay out at least 90% of their taxable income as investor dividends. This is good for investors, but it severely limits the funds available to grow the REIT. As such, since both the REIT and its investors want growth, they must turn to other options to finance that growth. The main venue a REIT will use to do so is the acquisition of debt.
This reality requires REITs to walk a fine line. On the one hand they need to borrow money to finance growth. On the other, they can easily run into the problems associated with debt that can affect anybody. High loan payments can be a sign of an aggressive growth strategy, but they can also make it difficult for the REIT to cover its expenses and pay dividends. Understanding what healthy debt looks like in a REIT is essential for an investor considering making an investment.
REIT Debt as a Financial Instrument
In addition to securing funds for acquisition and growth, there is another reason why a REIT may take on debt. This would be to repay existing debt. Although it sounds like an unwise business strategy – taking one loan to pay off another – at times it can make a lot of sense. When the funds were borrowed at a high interest rate, and interest rates subsequently dropped, refinancing a loan can result in significant savings.
Evaluating REIT Debt
When looking at debt on a REIT balance sheet, there are three main numbers to investigate:
- Debt to EBITDA ratio
- Debt maturity schedule
- Interest rate
Let’s look at each of these more closely.
REIT Debt and EBITDA Ratio
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It is a metric often used by financial analysts to compare the profitability of one company to another. For REITs it provides a useful benchmark to analyze the fund’s debt. The ratio between debt and EBITDA can give investors a sense of how much leverage the REIT is employing. The equation is simple:
Net Debt/ EDITDA = Debt to EBITDA ratio
If you find a low Debt to EBITDA ratio, it could indicate that the REIT is being conservative with debt. That can have a number of implications. The REIT may be draining its cash reserves unnecessarily instead of borrowing in a responsible manner. It can also mean that the REIT is not pursuing a growth strategy and is content to sit on its current assets. In either case, a low ratio should prompt an investor to do more research and inquire about the REIT’s goals and governance.
If you find a high Debt to EBITDA ratio, it may mean that the REIT is aggressively pursuing growth and is willing to invoke more leverage to do so. Obviously this strategy can be profitable, but it’s also potentially dangerous. Too much debt can make maintaining the fund’s health difficult and it could eventually lead to a collapse.
Many REIT investors look for a Debt to EBITDA ratio between 4 and 6. This range normally indicates a good balance between responsible management and growth strategy.
A debt maturity schedule gives you a timetable for when all the different debt elements will come due. Ideally an investor would like to see a consistent debt timetable with larger maturities being evenly distributed. If there is a large grouping of debt at some point in the future, that could be a red flag for the health of the fund. If the REIT is not properly prepared, they would have to address that debt in one of three possible ways:
- Issue more shares – In order to meet the debt obligation, the REIT can choose to raise money by offering more shares in the fund. This would adversely affect investors by diluting the value of the shares they currently own.
- Dividend adjustment – By having to funnel income to debt repayment, it can decrease the amount paid in dividends. In a more extreme scenario, the dividends could be cut altogether.
- Sale of assets – Selling properties is always a last resort for a REIT, as it is the properties that provides the fund’s value. However, if debt becomes untenable, a REIT may look to sell off key assets.
If you see an uneven or unusual distribution of debt, then it’s important to research the matter further. It’s perfectly justified to contact the REIT’s management team to get answers for your questions. Additionally, it doesn’t hurt to run the numbers by a seasoned investment professional. They will have acquired a sense for what the debt numbers indicate and whether or not the REIT is a plausible investment.
When discussing debt, it’s not just the amount of debt that matters, but how much will that debt cost the REIT. One of the ways that analyst look at this is with the interest coverage ratio. This gives a relative value for EDITDA in relation to the interest expense.
EBITDA / interest expense = interest coverage ratio
Analysts consider 3 or more to be an acceptable number. In that range the RIET will comfortably have the funds to cover the interest payments. Beneath that number may indicate that the REIT is overextended and may be in a danger zone.
To find out more about REITs and Debt, speak with a Madison specialist. Tell them about what you want to do, and they can give you more information. You can schedule a call here.