What are the Advantages and Disadvantages of Using Secured Versus Unsecured Debt?

By Lynn Novelli

REITs cannot live by equity alone. Like other companies, REITs must go to the debt markets for funding. Once there, however, they face a choice not presented to most other companies: should they use secured or unsecured debt?

Leaving aside equity financing, "most REITs use a combination strategy of secured and unsecured debt to gain access to capital and maintain a balanced risk level," explains Jamie Woodwell, senior director of commercial and multifamily research with the Mortgage Bankers Association.

LEVERAGE STATISTICS

Total Debt/Undepreciated Assets Overall REIT Industry < 46% High Grade REITs < 38%

Calculations are based on Credit Suisse fixed income REIT company average universe. Source: SNL Financial, Credit Suisse

The fact that most REIT assets are real estate—land plus fixed improvements—means that REITs have access to both unsecured and secured debt and can choose an optimal mix of the two sources of debt finance. However, there is no secret formula in choosing such a mix, says John Kriz, managing director, real estate finance, Moody's Investors Service. "The right mix is determined by whether it enhances flexibility and fits the company's business strategy. Capital structure can vary from a high level of one type of debt to virtually none, depending on the REIT's comfort level and business plan."

Unsecured Debt: Financial Flexibility

While secured mortgage debt represents a lien only on the specific properties that are pledged as collateral, unsecured debt in the form of corporate bonds provides investors with support of all of the REIT's assets and cash flows not otherwise pledged. Analysts agree that unsecured debt provides significant strategic and financial flexibility for a REIT because it is does not encumber assets.

For example, REITs can sell unencumbered properties to service debt obligations, and a ready market exists for commercial property, Kriz says. "If necessary, properties could even be sold piecemeal to pay debt, and unencumbered properties also can be mortgaged to generate cash." In contrast, Kriz notes, mortgages constain property owners' exit options because mortgaged assets are more difficult to sell.

TRANSACTION ACTIVITY

REIT Property Acquisitions vs. REIT Security Offerings Quarterly, 1992:Q1 – 2002:Q4 — In Billions

Calculations are based on our Credit Suisse fixed income REIT company average universe. Source: Credit Suisse

Compared with mortgage debt, the bond market is a faster source of financing, notes Thierry Perrein, managing director of Credit Suisse Securities Real Estate Finance and Securitization Group.

"Although bonds are not as quick as issuing equity, they

offer a fairly rapid access to capital, without the lengthy underwriting process required by mortgages," he says.

As short-term rates decline, REITs can increase unsecured borrowing with short- to medium-term maturities. The REIT bond market continues to grow rapidly, according to Credit-Suisse. REITs' issued $12.3 billion in unsecured bonds through the first eight months of 2006, a significant increase from the $9.9 billion issued through all of 2005.

"Despite this dramatic expansion, REIT bonds still represent only a small fraction of the total bond market," Perrein says. Of the total corporate bond market of approximately $4.5 trillion, just $90 billion is from REIT bonds.

As REITs expand their use of unsecured debt, investors interested in the stability and income of bonds relative to most equities have the opportunity to participate in real estate markets.

Capital Covenants

Usually REIT bonds contain covenants that became common after high real estate debt levels in the 1980s (coupled with a significant drop in real estate values) caused losses to lenders, leaving them wary of real estate-based debt.

"The general goal of the covenants is to place limits on a company's debt burden so that it does not overleverage itself," Perrein explains. Common covenant restrictions include a secured debt to total assets ratio of less than 40 percent; a total debt to total assets ratio of less than 60 percent; and an unencumbered assets to unsecured debt ratio of greater than 150 percent.

LEVERAGE STATISTICS

Secured Debt/Undepreciated Assets Overall REIT Industry <25% High Grade REITs < 12%

Calculations are based on our Credit Suisse fixed income REIT company average universe. Source: SNL Financial Credit Suisse

From the investors' perspective, covenant restrictions on REIT bonds have contributed to market growth over the past decade because they offer some degree of security for investing in companies that are constrained in their ability to retain cash. Interestingly, now that REITs are some 10 years into bond issuing under the covenants, the industry is looking to have some of the restrictions relaxed to give greater flexibility, Perrein says.

Unsecured REIT bonds are attractive to institutions that seek buy and hold investments, such as life insurance companies. Perrein estimates as much as 90 percent of REIT bonds are purchased by insurance companies.

This has been a strong year for REIT bond's issuance and analysts expect the flow to continue to grow unabated for the remainder of the year. "Issuance today on the REIT side has been very strong and well ahead of last year," Perrein says. "Also, the commercial real estate bond index is outperforming all other indexes by a wide margin, with the exception of all-lodging and technology. My expectation is that performance of REIT bonds in terms of total returns will continue."

Secured Debt: REIT-issued CMBS

Secured debt, REITs' second major source of public financing, takes the form of mortgages, which often are said by the mortgage providers to Wall Street firms that package then into commercial mortgage-backed securities (CMBS).

For mortgage issuers, CMBS enabled a profitable secondary market for commercial real estate debt. For investors, CMBS enable participation in the real estate debt market with a portfolio of specific risk and return profiles, without the hassles and risk involved in directly purchasing real estate debt.

For the REIT borrower, mortgages can offer a rate advantage versus unsecured debt, providing access to large amounts of long-term capital. "CMBS allow a REIT to leverage its equity to obtain more debt and buy more properties using a very liquid instrument at competitive rates," says Dottie Cunningham, chief executive officer of the Commercial Mortgage Securities Association (CMSA).

High values of commercial real estate coupled with lower mortgage rates have been driving the market for CMBS, and CMSA reports that CMBS are commanding a larger share of the commercial real estate finance market. The past 15 years have seen a steady increase in CMBS issuance, with an 81 percent year-over-year increase in 2005, pushing the total to a record $169 billion.

At the close of 2005, the outstanding volume of CMBS in the credit market reached $682.7 billion, including securities collateralized by loans on multifamily properties and other nonresidential properties. By the first quarter of 2006, securitized loans had grown to $709 billion, 26 percent of the $2.7 trillion mortgage market. CMBS currently represent about two-thirds of the total $1 trillion of the commercial real estate debt and equity securities that have been issued, according to the CMSA.

The CMBS industry applauds this expansion, noting it represents investors' wider acceptance of CMBS and commercial mortgage debt. "As a result, there is more capital flowing into the market," says Mortgage Bankers Association's Woodwell.

Nonetheless, only a handful of REITs are serious users of CMBS to finance their growth, reports Credit-Suisse's Perrein. "It's common knowledge that the major REIT players are General Growth Properties (NYSE: GGP) and Simon Property Group (NYSE: SPG)," he says. "However, these two companies recently have added more CMBS debt to their balance sheets in order to push up the numbers. I wouldn't call it a trend."

Equity Office Properties Trust (NYSE: EOP), which recently has expressed an interest in getting into the CMBS credit market, would make a third major player. Still, "a trend would mean a third or more of REITs using large amounts of CMBS, and that is not happening" Perrein says.

Overall, the ratio of secured debt to undepreciated assets is less than 25 percent in the REIT industry. Among high grade REITs it is less than 12 percent, according to Credit Suisse data.

Lenders can assemble CMBS ranging from a single property to an expansive portfolio of commercial mortgages. Most investors prefer portfolios of multi-loan pools that are diversified in terms of property types and locations, interest rate and maturities. CMBS may have fixed or floating rates and their value can range from $5 million to $1 billion or more.

Retail properties account for about 30 percent of issued CMBS, and office buildings make up another 25 percent, according to industry statistics.

Mortgages do come with some burdens for REITs, which may explain in part their limited use, Moody's Kriz says. A main drawback that he sees with mortgages is their lack of flexibility. "For example, the REIT cannot easily prepay a mortgage. Normal mortgage amortization, coupled with a rise in property values, means mortgage financing gradually becomes less and less efficient," he says. "Furthermore, mortgages contain numerous less obvious costs, such as legal reviews, the creation of special-purpose subsidiaries, appraisals and special financial reporting."

Despite these drawbacks, Kriz still says that mortgages can be useful when applied correctly. "Mortgages should be considered an arrow in the REIT's quiver of credit financing strategies," he says.

Rating REITs

The bulk of investment-grade REITs are rated Baa, a low investment grade rating, or Ba, a high non-investment grade rating. However, there are a number of more highly-rated REITs such as Public Storage (NYSE: PSA) with a rating of A3 and Weingarten Realty Investors (NYSE: WRI), which also has a rating of A3.

In some ways, REITs are a unique animal, Kriz says. "It's the nature of the beast that REITs are unable to retain cash, which should be of concern to investors," he says.

REIT credit ratings by Moody's Investors Service, Fitch Ratings and Standard and Poor's consider the REIT's total financial and strategic picture in determining ratings. REITs that seek an investment-grade rating typically try to maintain a debt plus preferred stock to gross asset ratio in the 40 percent to 50 percent range. A REIT's debt strategy is only one of several factors taken into consideration, but it can have a significant impact on the rating, Kriz says.

The type and tenor of debt are scrutinized as part of the analysis of leverage and capital structure. Although analysts look at a REIT's overall leverage, they also consider the relative level of secured debt, the amount of unencumbered assets and cash flow and the covenant packages that govern its unsecured debt.