By Michael M. Terry, CFA – Founder Rubicon Associates
About two months ago I wrote an article on bond covenants, what they are and how to use them. The types of covenants reviewed in that article are primarily used in industrial bonds and unsecured utility bonds. One of the comments the article generated was “I didn’t see a mention of the financial covenants”. That is because most investment grade bonds do not contain financial covenants – with one notable exception, REITs.
Real estate investment trusts are corporations that purchase and own real estate properties or real estate related financial obligations (such as debt or loans). Basically a REIT is a financial entity that raises money through issuance of equity, preferred stock, bonds or mortgages and uses the proceeds to purchase real estate related assets that generate a return on the investment through rents or other payments and capital gains. In this light it is possible to see that REITs have a cost of funds (issued securities or loans) and a return on funds (generated income and appreciation) and are, therefore, interest rate sensitive. As well, REITs are required to distribute at least ninety percent of their taxable income, which makes retaining cash somewhat difficult.
As REITs do not retain much cash from their operations, they are frequent security issuers when they purchase or develop properties or need to refinance their debt. As a result, investors in REIT bonds require assurances that a REIT will not borrow too much money and/or impair their ability to recover their investment in worst case scenarios. This is where REIT covenants come in.
Real estate investment trusts have a fairly standard set of covenants. As an example, there is the Regency Centers 4.80% notes due 2021. The notes contain the following covenants:
How do these covenants protect the fixed income investor? Let’s review them one by one:
1. Total Consolidated Debt to Total Consolidated Assets < 60%: As the assets of the REIT are mostly properties, this covenant helps ensure that debt does not overwhelm the assets (properties), which ensures there are assets to cover debt in a worst case scenario.
2. Secured Consolidated Debt to Total Undepreciated Assets <40%: This covenant helps ensure that the REIT’s assets are not all encumbered by loans, again protecting REIT bond holders for a REIT taking on too much debt, especially secured debt.
3. Consolidated Income for Debt Service to Consolidated Debt Service >1.5x: This covenant helps assure bond holders that the REIT has the means to pay their interest and principal at maturity.
4. Unencumbered Consolidated Assets to Unsecured Consolidated Debt >150%: This covenant makes sure that for every $1.00 in debt, a REIT has $1.50 in unencumbered assets (assets that are free to be sold without any other claimholders coming before the bondholders).
As many bond investors realize, keeping up with covenant compliance can be difficult – waiting for financials, adjusting assets for covenant definitions and crunching the numbers. REITs, however, make the life of a fixed income investor easier as they disclose their covenants and compliance with those covenants quarterly in a document known as a quarterly supplement. An example of Regency Center’s disclosure is:
You will notice that there are two sets of covenants. REITs used to use historical cost based covenants, but have transitioned into consolidated assets.
The bottom line is that real estate investment trusts are one of the only sectors of the investment grade fixed income markets to have financial covenants which control the ability of the REIT to jeopardize fixed income investors by incurring too much debt.