REITs are turning to convertible bonds as an attractive capital solution.

By Charles Keenan

In January 2007, Boston Properties Inc. (NYSE: BXP) wanted to raise cash to help repay debt, pursue development projects and fund future acquisitions. But instead of going the standard route of issuing equity or debt, or obtaining a secured mortgage, the REIT tapped a corporate financing mechanism increasingly popular among its peers.

The company issued $862.5 million in convertible bonds that it will settle in cash or stock at its call date in five years. The issuance follows $450 million in convertible bonds that Boston Properties brought to market last year.

"We see convertible bonds as an additional piece of our capital structure," says Michael Walsh, senior vice president of finance at Boston Properties. "They are an attractive source of debt."

Like unsecured bonds or commercial mortgage-backed securities (CMBS), convertible bonds add to the financing options available to REITs. The debt instrument has been in the larger financing community for some time, but REITs are just beginning to tap this resource.

Before 2005, issuance of convertible bonds by REITs was limited to only a few deals per year. According to SNL Financial, issuance jumped from 13 completed deals worth $1.9 billion in 2005 to 29 deals worth $10 billion in 2006. The pace is brisk so far for 2007 as well, with nine deals worth approximately $4 billion completed as of mid-March.

The demand for REIT convertibles comes from a convergence of factors. The real estate bull market has bid up prices for REITs and properties, driving down capitalization rates. That makes it harder for REITs to fund acquisitions and growth at current interest rates, making the lower pricing on convertible bonds attractive.

Driving Demand

With low capitalization rates and ample liquidity in the markets, many REITs are finding that a dash of convertible bonds on the balance sheet is irresistible. According to Fitch Ratings, coupon rates on convertible bonds are typically 200 basis points below those on general unsecured bonds. Boston Properties' January issuance had a coupon of 2.9 percent and an effective rate of 3.4 percent. With rates like these, REITs have lined up for a slice of the capital.

Like Boston Properties, other big REIT names have tapped the market. Larger offerings include a $1 billion sale by Vornado Realty Trust (NYSE: VNO) last November, and a $1.5 billion offering last June by Equity Office Properties Trust. (Equity Office was acquired earlier this year by private equity firm The Blackstone Group.)

Convertible Bonds Convertible bonds are hybrid securities, offering both debt and equity features. One part of the security is a senior unsecured note with a fixed rate coupon. The other part is a warrant that allows the investor to convert the security into common stock or cash at specified dates in the future. The warrant is basically an option overlay on the bond. The option portion allows issuers to reduce the coupon rate on the bonds in return for the option granted to investors.

Other large issuances include a $575 million offering by Duke Realty Corporation (NYSE: DRE) in November 2006, and a $575 million sale by Archstone-Smith (NYSE: ASN) last July.

The wave of convertible debt offerings comes at a time when financing of all kinds—ranging from revolving lines of credit to commercial mortgages to unsecured bonds—is cheap. "There is a tremendous amount of liquidity out there and REITs are benefiting from it," says Jan Svec, director of the REIT rating group at Fitch Ratings. "Everybody is getting favorable pricing."

Five-Year Plan

Convertible bonds are subordinate to secured mortgage debt, and equal on the capital scale to traditional senior unsecured notes. Typically, convertible bonds have anywhere from five- to 30-year terms—with trigger points every five years—but most REITs plan to take out the debt after five years, Svec says. Most also carry terms that REITs can settle in cash, so they won't be required to issue shares. "It is pretty cheap five-year financing," Svec says.

On the call date, REIT investors pay either in cash or in cash and stock. In essence, convertible bonds are a bond with an option overlay. The option comes with a strike price, which is the stated price per share for underlying stock at the time the option is exercised. Typically the strike price is 20 percent or more above the price at issuance.

If the price of the stock is above the strike price at the call date, then it is in the money. In that case, the REIT must pay the investor the face amount of the bond portion, plus the amount the option is in the money. If the option were not in the money, the REIT then would owe just the face amount of the bond.

REIT Convertible Offerings in 2007*
COMPANY NAME	COUPON	DATE	GROSS AMOUNT OFFERED ($ MILLIONS)
Alexandria Real Estate Equities, Inc.	3.70%	1/11	460
Washington Real Estate Investment Trust	3.88%	1/17	150
Lexington Realty Trust	5.45%	1/24	300
Boston Properties, Inc.	2.88%	1/31	862
Hospitality Properties Trust	3.80%	3/2	575
Developers Diversified Realty Corporation	3.00%	3/7	600
Lexington Realty Trust	5.45%	3/9	150
Macerich Company	3.25%	3/12	800
Total			4,047
*Through mid-March; Source: SNL Financial

In effect, investors in convertible bonds are betting that the issuing REIT's stock price will appreciate to more than the strike price—with the REIT's growth boosted by the improvements in its balance sheet made possible through low-cost financing, says Brad Case, vice president of research and industry information at NAREIT.

Hedge funds, in fact, are driving much of the demand for REIT convertibles, using them as an arbitrage opportunity. The bet: invest in the convertible security while shorting the stock in the short term. Plating both sides enables hedge funds to smooth their returns—a prime consideration for most.

"Hedge funds are saying, 'Here's a way we can provide the financing that REITs want while getting the yield and return our shareholders want,'" Case says.

Convertible bonds can help REITs hold off on issuing additional shares of common stock, delaying dilution of shares and earnings into the future, Svec says. "Many REITs are using some of the proceeds to buy back stock, which is immediately accretive to earnings per share and offsets some of the potential future dilution in earnings," she says. As with Boston Properties, proceeds can also be used to repay debt, pursue development or make acquisitions.

More Flexibility

With recent appreciation of real estate prices, REITs are relying on convertible bonds to maintain the spread on the assets they are buying. Ten years ago, capitalization rates were much higher, enabling REITs to pay higher yields. Now REITs are feeling the interest-rate squeeze.

"You are potentially giving up some equity dilution to get an upfront spread," says Lisa Sarajian, a managing director at Standard & Poor's ratings agency. "Ten years ago, you could have bought an apartment complex for a 9 percent cap rate, financed it at 7 percent, and earned a nice spread. The cap rates are now down to 5 percent and 6 percent. You can't buy an asset unless you can finance it at some marginal spread."

However, many warn that convertibles, for all of their advantages, come with a price. Essentially, REITs bet the stock appreciation won't be so much as to make the conversion an expensive proposition. Also, if interest rates spike upward, companies might be forced to pay investors in stock, which would be dilutive.

"You eventually have to pay the piper," says Mike Kirby, director of research at Green Street Advisors, a research and consulting firm. "There is a reason investors are willing to accept a coupon that is below market of just straight debt. They put a meaningful value on the call option embedded in these things."

Convertible Bonds Versus Covenants Besides the low rates, convertibles offer more flexibility compared with more traditional financing, such as mortgage debt and unsecured senior notes. While secured mortgage debt offers access to large amounts of capital for the long term, REITs face drawbacks—they usually cannot easily prepay a mortgage, and mortgaged assets are more difficult to sell. While unsecured bonds allow REITs to sell unencumbered properties—or mortgage them to raise cash—they also restrict issuers through covenants. Those covenants, which seek to prevent REITs from overleveraging, often specify that the ratio of secured debt to total assets ratio cannot exceed 40 percent, the total debt to total assets cannot exceed 60 percent and the ratio of unencumbered assets to unsecured debt must be at least 150 percent. REIT bonds' use of covenants came about in part as a reaction to the weak covenants used in the late 1980s, when many debt investors suffered losses after a significant drop in property values sent highly leveraged companies reeling. By contrast, convertible bonds don't include covenants that restrict borrowing. "Issuing companies governed by conventional or traditional REIT bond indenture still have to manage business within the confines of the indenture," says Lisa Sarajian, managing director, Standard & Poor's. "But convertible issues wouldn't be governed by that." Most REITs carry unsecured notes on the balance sheet, which restricts how much leverage they can take. However, if a REIT were to slowly wean itself off of traditional unsecured notes, the company might no longer be bound by today's bond covenants, Sarajian says. "A company is still going to operate within those guidelines of the unsecured debt when they issue these converts, but if the senior debt ever went away, they wouldn't be subject to as restrictive a covenant package," she says.

While Kirby characterizes the pricing on convertibles as "fair," he says he fears that some REITs use convertibles to help manage earnings, noting that only in the out years—when a convertible bond moves into the money—does the embedded cost come into play.

Depending on the market demand by investors, convertible bonds could continue to grow as an instrument in the coming years. By and large—as with other debt—ratings agencies want REITs to have a good idea of the potential impact on their debt servicing down the road. "We want to see companies model this structure, so they are managing their debt maturity schedules thoughtfully and ensuring that they maintain strong debt service coverage of all their obligations," Sarajian says.

Still, rating agencies remain confident that REITs that have issued convertible debt will have covered cash settlement exchanges and potential redemptions in five years. Despite the risk around the payout, convertibles are a nice addition to the balance sheet, rating agencies say, because through them REITs get access to the capital of hedge funds.

"Management teams should be focusing on managing their balance sheet so that they have access to varied sources of capital which includes varied investors," Sarajian says. "The balancing act is making sure you are not overweighted within any one category in order to avoid being subject to whatever swings might occur in any of those."