REITs have been busy tapping commercial banks for term loans and lines of credit. That borrowing has raised added scrutiny from ratings agencies who tend to frown on the over-reliance on a single capital source.
According to a new report by ratings firm Fitch, the U.S. REIT sector has seen a “significant” increase in commercial bank borrowing in recent years. At the end of 2016, bank borrowing exposure, including outstanding amounts on unsecured revolving credit facilities and term loans, accounted for 16.5 percent of total debt. Although that is an improvement from the 18.8 percent a year ago, it is still hovering near a 10-year high and is well above the 8.5 percent from year-end 2010.
The “failure” of REITs to capitalize on the strength of the unsecured bond market to reduce bank borrowings is increasing liquidity and funding risk, according to Fitch Ratings. One concern of the elevated exposure is that REITs may max out bank borrowing now when financing is still available and not have enough “dry powder” in terms of financing options if credit starts to tighten.
The REIT structure doesn’t allow REITs to hold extra capital in reserve as earnings must be passed on to shareholders. Yet real estate is a capital-intensive business and REITs need to have a healthy access to multiple sources of capital.
“If one of those forms of capital goes away, that could be problematic, particularly if it is during a period where they need to access capital and they can’t do so any longer from their bank relationships,” says Steven Marks, managing director, corporate finance, at Fitch.
“Capital market access is extremely important to REITs,” adds Chris Wimmer, vice president and head of REITs at Morningstar Credit Ratings. REITs access capital through public, private, debt and equity sources. “To the extent that REITs can demonstrate access to each of those four quadrants, that gives them a better credit profile,” says Wimmer.
Morningstar Credit Ratings is in the process of developing methodology for rating the REIT industry, and does not currently have any ratings on publicly-traded REITs.
Banks offer flexibility
Part of what may be frustrating some ratings agencies is that the higher level of bank borrowing comes at a time when the bond market is quite robust. Yet REITs have been turning to the banks for financing for a couple of reasons. Banks have been aggressive in courting new business and are offering five- and seven-year loans. REITs may also be relying more on bank financing simply because of the flexibility it offers.
“What the commercial banking market provides is that it is not necessarily cheaper, but it is more flexible in the extent of the maturities,” says Philip Kibel, associate managing director, real estate finance, at Moody’s Investors Service. For example, REITs can get three-, five- or even seven-year debt that can fit nicely into their maturity schedule with no pre-payment penalties, he notes.
The current level of 16.5 percent in bank borrowing exposure is likely close to a high-water mark for the industry as a whole. In fact, it has dropped lower from the 18.8 percent that existed at the end of 2015 after a record year of real estate investment sales.
“We don’t think it is going to get demonstrably higher. We think it is going to stay below 20 percent,” says Marks. Most REITs do keep a careful watch on their credit profiles. Banks are also wary of REIT exposure and have their own lending constraints. At the same time, the level of bank financing isn’t likely to decline meaningfully either, notes Marks.
More scrutiny ahead
The higher level of bank borrowing has moved REITs’ access to capital more firmly onto the radar of ratings agencies and analysts. However, at the end of the day, the positive or negative impact on bank borrowing levels needs to be determined on a case-by-case basis.
Heavy reliance on bank financing is a bigger red flag among newer, smaller REITs who have not been consistent bond issuers.
“We view that sort of structure as a relatively immature capital structure and not sustainable and not representative of an investment grade profile,” says Marks. “So we do like to see REITs being able to access the unsecured bond markets to diversify their sources of capital.”
Ratings agencies are keeping a close eye on how bank loans and revolvers fit into overall maturity schedules. So far, bank borrowing levels have not been cause for any downgrades or negative credit rating actions.
“As it relates to bank lines of credit, we have seen REITs be very prudent in their usage of lines,” says Kibel. Very few of the investment-grade REITs that Moody’s follows have a significant amount outstanding on their lines and a lot of them have been very aggressive in refinancing them before their due date, he says.