Increased Uncertainty for REITs
Our rationale for increasing the fair value uncertainty ratings for many of the real estate investment trusts that we cover.
We've decided to increase the fair value uncertainty ratings for many of the real estate investment trusts that we cover to better account for the wide range of possible outcomes for these firms over the next few years. In the fourth quarter of 2008, we moved our entire coverage universe of 68 REITs to either high or very high uncertainty as it became clear that falling asset values and excessive leverage in most property types was a toxic combination. Given recent signs of additional distress, we're moving 21 companies to very high uncertainty from high. After this update we'll have 19 REITs at high and 49 at very high. In addition, we're raising some of our assumed credit spreads--which increases the firm's cost of debt and overall cost of capital in our valuation models--to more accurately reflect the exceptionally difficult lending environment.
Increased uncertainty ratings lower our Consider Buying prices, meaning that we believe a larger margin of safety is necessary to properly account for the possible spectrums of cash-flow generation and discount rates. The only certainties right now in commercial real estate are that rents and asset values are falling and are likely to fall further. The primary uncertainty--which our larger margins of safety should capture--is the magnitude of these declines. Although we've modeled material, and in some cases severe, downturns in each of our discounted cash-flow models, the constant stream of abysmal economic data makes it nearly impossible to peg where fundamentals will ultimately find a floor.
REITs are leveraged business models that find themselves squeezed between floundering banks and struggling tenants in nearly every industry. Lending has virtually vanished for commercial real estate, especially from the commercial mortgage-backed securities market that was the dominant source of liquidity from 2005 until early 2008. In addition, with common and preferred equity and outstanding debt prices implying prohibitively expensive costs of capital, raising funds, both incremental and refinancing, has proved highly dilutive. Therefore, we've decided that all REITs with total debt/property values (a rough loan/value proxy that assumes all unsecured debt must become secured once refinanced) over 55% and interest coverage (i.e., EBITDA/interest) under 2 times are very high uncertainty investments. Various recent events, such as Developer's Diversified Realty's (DDR) dilutive equity issuance (see note), indicate that lenders are balking at leverage greater than these thresholds.
If that weren't bad enough, tenants in nearly all property types are grappling with unprecedented head winds as the recessions deepens. Hotels, the most discretionary of REITs, are facing plummeting nightly rates and occupancy as unprecedented supply comes on market at the same time that demand evaporates. Retail REITs must contend with an increase in supply nearly as severe as with hotels and rapidly falling consumer demand--a characteristic sure to cause retail tenants to cease most expansion plans and close existing stores in some cases. Recent retailer bankruptcies like Circuit City, KB Toys, Linens 'n Things, and Mervyn's are timely examples of this trend. While office and industrial REITs don't seem to be facing the same excesses in property supply, global economic woes and swelling unemployment will undoubtedly weigh on performance. Lastly, we don't expect severe outcomes at most apartment and health-care REITs, but it's safe to say the next few years will be more challenging than the last few.
Large development pipelines and significant joint venture investments are also red flags. It's not hard to understand why building new properties in an already oversupplied environment is worrisome. While some management teams touted themselves as "build-to-suit" developers, poor preleasing rates--many ranging from 0% to a still-uneconomic 70%--prove otherwise. Needless to say, returns on these investments will be a fraction of what blueprints predicted. Joint ventures are just as concerning. Financial disclosures are often opaque at these largely off-balance-sheet entities, and while their purposes range widely, in some cases they were created to facilitate highly leveraged properties or speculative developments. Fortunately, most of the related debt is non-recourse to the REITs we cover, so at this time we don't forecast any negative value drains on our valuations. Still, we've put any firms that derive more than 10% of their value from development pipelines or joint ventures in the very high uncertainty bucket.
We're also skeptical of all firms that hope to sell assets to meet debt maturities. Commercial real estate transactions are down globally between 50% and 90% depending on the estimate and geography considered, as the lack of financing, increased property supply, uncertain rent outlook, and general dearth of buyers have generated a massive bid ask spread: Essentially no one knows what these assets are worth so all parties are paralyzed. Even lenders appear hesitant to force the hand of their distressed counterparties because taking possession and then dumping properties into such an illiquid market does not seem to be the "least-lost" solution. (This scenario is evident at General Growth Properties (GGP). Follow this link to see all of our commentary on this in-progress saga.) Therefore, we require very high margins of safety for any REITs that can't fund upcoming debt maturities with cash flow or existing lines of credit.
One final method we're using to determine whether a REIT should be considered a very high uncertainty investment depends on the target markets that the REIT's property portfolio serves. Basically, any firm with most of its assets in tertiary markets (especially in retail) and suburban areas (especially in office) warrants an increased uncertainty rating, as these locales are more likely to see sharper reductions in rents and asset values, in our opinion.
Lastly, we've increased our assumed credit spreads for some REITs to reflect the shifting risk tolerance of lenders. While it's hard to say what each firm will ultimately pay as its debt comes due, we're confident that interest rates will be higher than outstanding debt on their balance sheets. As we noted earlier, in assessing a firm's leverage, we assume that all outstanding unsecured debt must become secured when refinanced. The reason for this is that REITs are--roughly--on average junk credits. With the high-yield market essentially shut down, unsecured debt is no longer an option for most firms. The impact of this higher credit spread rollout is lower fair values with the reduction varying company by company.
In short, REITs are facing a perfect storm and, as in any dislocation of the magnitude we currently face, it's exceptionally difficult to know where all the pieces will land. We will monitor the situation closely as it appears the turmoil in commercial real estate and economies around the world will not end any time soon.
Here's a breakdown of our uncertainty ratings after this update.
Joel Bloomer does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.