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In the article “Cap Rate Spread: Leading Indicator of Non-Listed REIT Performance,” I highlighted how the cap rate spread is the key indicator of long-term performance of REITs. Investors also need to understand the balance sheet risk of REITs, as REITs can take on both investment and financing risk to inflate their cap rates. This additional risk may boost near-term performance, but this risk can negatively impact long-term returns.

On the investment side, REITs can inflate cap rates by investing in lower quality tenants, shorter lease terms, or weaker markets. Investment risk becomes a concern, if the risk reflects a shift in investment strategy. But, debt financing risk can pose a significantly greater risk to REITs and their investors. We’ve seen the dangers of high financing risk play out after the credit crisis of 2007, specifically with some high profile publicly traded REIT bankruptcies.

With a healthy credit market, as we are now seeing in commercial real estate, REITs have access to long-term, fixed rate debt at attractive interest rates. REITs that utilize a conservative long-term financing strategy can boost their equity yields without significant additional risk to the REIT. However, if a REIT departs from such a conservative strategy and takes on high leverage, interest rate risk, or short-term financing risk, they can add substantial risk to their REIT.

High leverage can be particularly devastating in a period of declining commercial real estate values, as we saw from 2007 to 2009. REITs refinancing in this environment are forced to provide additional equity to refinance their assets, as banks will base their lending on the lower value. This refinancing process, known as deleveraging, has a significant negative impact on total returns. High leverage will be less of a risk for newer REITs buying at favorable prices.

Interest rate risk refers to the degree of variable rate debt held by a REIT. Commercial real estate lenders typically offer fixed rate financing; however, variable rate debt may be a less expensive option. Many REITs will originate variable rate debt then purchase an interest rate swap to effectively fix the interest rate at a lower rate than available with a fixed rate loan. A high percent of variable rate debt puts REIT yields at risk if we see rising interest rates.

Short-term financing risk poses the most significant debt financing risk. Today, REITs can originate seven- or ten-year loans at attractive interest rates. However, three- or five-year loans can offer a much lower interest rate and boost short-term leveraged yields. Many REITs will stagger their debt maturities, but a high percentage of short-term debt can put the REIT at significant risk, as interest rates will inevitably rise and refinancing will come at a higher cost.

In analyzing debt financing risk, I utilize a 50/25/25 benchmark for the three debt financing risks. A REIT with greater than 50% leverage, 25% variable rate debt (unswapped), and/or 25% short-term debt (maturing in less than three years) will have moderate to high debt financing risk. An investor should understand the debt financing risk of a REIT before he or she makes an investment. High debt financing risk is an unnecessary and avoidable risk for investors.

The tables below list several REITs (across different commercial real estate sectors) with low debt financing risk. These REITs are using primarily long-term, fixed rate debt with low interest rates at moderate leverages. This conservative financing strategy will help protect the equity yields of these REITs, particularly against the negative impacts of rising interest rates.

Publicly Traded REITs

Leverage Ratio (Debt/Cost)

Variable Rate Debt Ratio

Short-Term Debt Ratio

Alexandria Real Estate (NYSE:ARE)

42%

18%

51%

DCT Industrial Trust (NYSE:DCT)

41%

34%

18%

Equity One (NYSE:EQY)

44%

13%

15%

Liberty Property Trust (LRY)

43%

13%

0%

Realty Income (NYSE:O)

39%

6%

6%

Effective Non-Listed REITs

Leverage Ratio (Debt/Cost)

Variable Rate Debt Ratio

Short-Term Debt Ratio

CB Richard Ellis Realty Trust

32%

0%

12%

Cole Credit Property Trust III

38%

6%

22%

Corporate Property Assoc. 17 - Global

35%

19%

5%

Hines Global REIT

44%

0%

2%

Industrial Income Trust

55%

15%

17%

Inland Diversified Real Estate Trust

53%

13%

21%

Most REITs utilize a leverage investment model. AEI Core Property Income Trust, a new non-listed REIT currently in registration, will utilize an all-cash investment strategy and avoid the risks associated with debt financing. AEI Capital, the REIT’s sponsor, has more than forty years of expertise in managing net lease real estate funds. AEI Core Property Income Trust will provide an attractive alternative for investors wary of the risk of commercial real estate leverage.

Any investor considering REITs should understand the REIT’s debt financing risk, in addition to the REIT’s fee structure, risks and expected returns. An understanding of the debt financing risk will help investors understand the potential risks and avoid REITs with a risk profile that exceeds their comfort level. Investors have several great REIT options that minimize debt financing risk and help protect the expected total return from a REIT investment.

Source: Understanding Balance Sheet Risk In REITs