Why We Love Boring REIT Bonds

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Includes: EPR, UA
by: Brad Thomas

Summary

We believe REIT bonds are compelling for more than just their yields.

Investment grade REIT bonds contain what very few investment grade bonds contain – financial covenants.

I will walk through the prospectus and point out the information used in understanding the deal.

I was recently looking at a bond issue by a REIT that I thought investors might have an interest (no pun intended).

During the course of my investigation into the issue, it dawned on me that I have never really seen anyone go through the prospectus and point out the items of interest and why they are interesting.

Some investors may be familiar with the prospectus and the covenants offered by REIT bonds, but I thought it might be time to do a refresher article on the prospectus generally and the covenants. Many folks (including myself) reference the prospectus or provide a link to it, but perhaps it is time to go through it.

By way of background, I have spent over two decades analyzing, trading and managing institutional bond portfolios, and during that time, I have always been fond of REIT debt in the credit space (I have, at one time or another, invested in MBS, CMBS, ABS, credit, preferred and equities for my various employers).

The reason?

Financial covenants and attractive spreads. With that said, let's take a walk through the prospectus (due to the sheer amount of content, my comments will be italicized. All emphasis is mine).

For this example, we will be using the prospectus for EPR Properties (NYSE:EPR) 4.50% Notes due 4/1/2025 (CUSIP: 26884U AB5).

(424B5 - Prospectus - this example is found here)

Guarantees

The notes will be unconditionally guaranteed, jointly and severally, on a senior unsecured basis by our current and future subsidiaries that guarantee our unsecured revolving credit facility, our unsecured term loan facility and our existing 7.750% Senior Notes due 2020, 5.750% Senior Notes due 2022 and 5.250% Senior Notes due 2023.

A Guarantor may not sell or otherwise dispose of all or substantially all of its assets to, or consolidate with or merge with or into (whether or not such Guarantor is the surviving Person), another Person, other than the Issuer or another Guarantor, unless:

  1. Immediately after giving effect to that transaction, no Default or Event of Default exists under the Indenture; and
  2. Subject to the provisions of the following paragraph, the Person acquiring the property in any such sale or disposition or the Person formed by or surviving any such consolidation or merger assumes all the obligations of that Guarantor under the Indenture and its Guarantee pursuant to a supplemental indenture satisfactory to the Trustee.

This section is relatively straightforward. Across all sectors, an investor should know who guarantees the debt.

Ranking

The notes will be our and the guarantors' general senior unsecured obligations, will rank equal in right of payment with all of our and the guarantors' existing and future senior indebtedness, including our unsecured revolving credit facility, our unsecured term loan facility, and our existing notes, and will rank senior in right of payment to all of our and the guarantors' existing and future subordinated indebtedness.

However, the notes will be effectively subordinated to all secured indebtedness to the extent of the value of the collateral securing such indebtedness. The notes will also be structurally subordinated to the indebtedness and other obligations of the non-guarantor subsidiaries with respect to the assets of such entities.

The non-guarantor subsidiaries accounted for approximately $112.3 million, or 29.2%, of our total revenues and approximately $36.3 million, or 20.2%, of our net income for the year ended December 31, 2014. The non-guarantor subsidiaries accounted for approximately $1.1 billion, or 29.4%, of our total assets, and approximately $426.8 million, or 24.0%, of our total liabilities as of December 31, 2014. Excluded from these total revenues, net income, total assets, and total liabilities are certain intercompany balances that are eliminated in consolidation.

Again, relatively straightforward. This shows the level in the capital structure, the issue you are looking at falls. While most REIT debt will be senior unsecured, debt of industrials and banks can have multiple layers. It is always important to know how much debt comes ahead of you in terms of seniority.

Optional Redemption

The Issuer will not be entitled to redeem all or any portion of the Notes at its option except as provided in this section. The Issuer will be entitled at its option to redeem all or any portion of the Notes at a redemption price equal to 100% of the principal amount of such Notes plus the Applicable Premium as of, and any accrued and unpaid interest to, but not including, the redemption date (subject to the right of the holders of Notes on the relevant record date to receive interest due on the relevant interest payment date); provided, that if the Notes are redeemed on or after 90 days prior to the maturity date, the redemption price will be 100% of the principal amount of the Notes being redeemed plus accrued and unpaid interest to, but excluding, the redemption date. Notice of such redemption must be mailed by first class mail to each noteholder's registered address, not less than 30 nor more than 60 days prior to the redemption date. The notice of redemption will specify, among other items, the redemption date, the redemption price, and the principal amount of the Notes held by the holder to be redeemed.

Know if your bonds are callable, and at what price. This becomes important when investing at a premium and calculating the premium owed if your bonds are called.

Certain Covenants

Limitations on Incurrence of Debt

Debt to Assets: The Issuer will not, and will not permit any Restricted Subsidiary to, incur any additional Debt if, immediately after giving effect to the incurrence of such additional Debt and the application of the proceeds thereof, the aggregate principal amount of all of the Issuer's and its Restricted Subsidiaries' outstanding Debt on a consolidated basis determined in accordance with GAAP would be greater than 60% of the sum of (without duplication):

  1. The Total Assets of the Issuer and its Restricted Subsidiaries as of the end of the calendar year or quarter covered by the Issuer's Annual Report on Form 10-K or Quarterly Report on Form 10-Q, as the case may be, most recently filed with the Commission (or, if such filing is not permitted under the Exchange Act, as of the end of the calendar quarter covered by the Issuer's most recent report filed with the Trustee) prior to the incurrence of such additional Debt (the "Measurement Date"); and
  2. The purchase price of any Real Estate Assets or mortgages receivable acquired, and the amount of any securities offering proceeds received (to the extent that such proceeds were not used to acquire Real Estate Assets or mortgages receivable or used to reduce Debt), by the Issuer or any of its Restricted Subsidiaries on a consolidated basis since the Measurement Date (such sum of clauses (1) and (2) being collectively referred to as " Adjusted Total Assets").

Secured Debt to Assets: In addition to the above limitations on the incurrence of Debt, the Issuer will not, and will not permit any Restricted Subsidiary to, incur any Secured Debt if, immediately after giving effect to the incurrence of such additional Secured Debt and the application of the proceeds thereof, the aggregate principal amount of all of the Issuer's and its Restricted Subsidiaries' outstanding Secured Debt on a consolidated basis in accordance with GAAP is greater than 40% of Adjusted Total Assets.

Debt Service Coverage: In addition to the above limitations on the incurrence of Debt, the Issuer will not, and will not permit any Restricted Subsidiary to, incur any Debt if the ratio of Consolidated Income Available for Debt Service to the Annual Debt Service for the four consecutive fiscal quarters ended on the Measurement Date shall have been less than 1.5x, on a pro forma basis after giving effect to the incurrence of such Debt and to the application of the proceeds therefrom, and calculated on the assumption that (conditions may/will follow).

Maintenance of Total Unencumbered Assets: The Issuer and its Restricted Subsidiaries will maintain Total Unencumbered Assets as of the end of each fiscal quarter of not less than 150% of the aggregate outstanding principal amount of the Issuer's and its Restricted Subsidiaries' Unsecured Debt as of the end of each fiscal quarter, all calculated on a consolidated basis in accordance with GAAP.

Merger, Consolidation or Sale

The Issuer may not, directly or indirectly: (1) consolidate or merge with or into another Person (whether or not the Issuer is the surviving corporation); or (2) sell, assign, transfer, convey, lease (other than to an unaffiliated operator in the ordinary course of business) or otherwise dispose of all or substantially all of the properties or assets of the Issuer and its Restricted Subsidiaries taken as a whole, in one or more related transactions, to another Person; unless:

  1. Either: (NYSE:A) the Issuer is the surviving corporation or trust; or (NYSE:B) the Person formed by or surviving any such consolidation or merger (if other than the Issuer) or to which such sale, assignment, transfer, conveyance or other disposition has been made is a corporation or trust organized or existing under the laws of the United States, any state of the United States or the District of Columbia;
  2. The Person formed by or surviving any such consolidation or merger (if other than the Issuer) or the Person to which such sale, assignment, transfer, conveyance or other disposition has been made assumes all the obligations of the Issuer under the Notes and the Indenture pursuant to agreements reasonably satisfactory to the Trustee; and
  3. Immediately after such transaction, on a pro forma basis giving effect to such transaction or series of transactions (and treating any obligation of the Issuer or any Restricted Subsidiary incurred in connection with or as a result of such transaction or series of transactions as having been incurred at the time of such transaction), no Default or Event of Default exists under the Indenture.

Always watch out for the "sale of all or substantially all" language. There has been no "bright line" set that determines what "substantially all" is considered.

Events of Default, Notice, and Waiver

The Indenture provides that the term "Event of Default" with respect to the Notes means any of the following:

  1. The Issuer or its Restricted Subsidiaries do not pay the principal or any premium on the Notes when due and payable;
  2. The Issuer or its Restricted Subsidiaries do not pay interest on the Notes within 30 days after the applicable due date;
  3. The Issuer or its Restricted Subsidiaries do not comply with its obligations under "-Merger, Consolidation or Sale";
  4. The Issuer or its Restricted Subsidiaries remain in breach of any other term of the Indenture for 60 days after they receive a notice of Default stating they are in breach. Either the Trustee or the holders of more than 25% in principal amount of the then outstanding Notes may send the notice;
  5. Final judgment aggregating in excess of $50.0 million (exclusive of amounts covered by insurance) are entered against the Issuer and its Restricted Subsidiaries and are not paid, discharged or stayed for a period of 60 days;
  6. The Issuer or its Restricted Subsidiaries default under any of their indebtedness in an aggregate principal amount exceeding $50.0 million after the expiration of any applicable grace period, which default results in the acceleration of the maturity of such indebtedness. Such default is not an Event of Default if the other indebtedness is discharged, or the acceleration is rescinded or annulled, within a period of 30 days after the Issuer or its Restricted Subsidiaries receives notice specifying the default and requiring that they discharge the other indebtedness or cause the acceleration to be rescinded or annulled. Either the Trustee or the holders of more than 25% in principal amount of the then outstanding Notes may send the notice;
  7. The Issuer or any of its Significant Subsidiaries or any group of Subsidiaries that, taken as a whole, would constitute a Significant Subsidiary files for bankruptcy or certain other events in bankruptcy, insolvency or reorganization occur; or
  8. Any Guarantee of a Significant Subsidiary of the Issuer ceases to be in full force and effect or is declared null and void or any Guarantor denies or disaffirms its obligations under the Indenture or any Guarantee other than by reason of the release of any such Guarantee in accordance with the Indenture.

Of these provisions, #6 (and to a lesser degree #5) is the most important as it identifies the amount of debt the issuer has to default on in order to trigger a company-wide default. The lower the amount, the better.

Modification of the Indenture

Except as provided in the next two succeeding paragraphs, the Indenture and/or the Notes may be amended or supplemented with the written consent of the holders of at least a majority in principal amount of the then outstanding debt securities issued under the Indenture affected by such amendment or supplement voting as a single class (including, without limitation, consents obtained in connection with a purchase of, or tender offer or exchange offer for, such Notes) and any existing Default, Event of Default (other than a Default or Event of Default in the payment of the principal or premium, if any, of or interest on the debt securities, except a payment default resulting from an acceleration that has been rescinded) or compliance with any provision of the Indenture or the Notes may be waived with the consent of the holders of a majority in principal amount of the then outstanding debt securities issued under the Indenture affected thereby voting as a single class (including, without limitation, consents obtained in connection with a purchase of, or tender offer or exchange offer for, the Notes).

The definition of the amount of holders necessary to modify the indenture can be important. It is always best if this takes place by series rather than class, as control of a series can give an investor leverage. Mostly, however, it is voting as a single class.

Reporting

In addition to having some of the best covenants in the investment grade debt space, REITs also do a bang-up job reporting on where they stand versus their covenants. This reporting typically takes place in the quarterly supplemental. For EPR, it is shown in their supplemental as:

Now, let's compare the REIT covenants to the covenants contained in Under Armour's (NYSE:UA) new 3.25% ten-year senior unsecured debt (rated Baa2/BBB- - prospectus here, term-sheet here):

Certain Covenants

The indenture governing the notes will contain covenants limiting our ability and certain of our subsidiaries' ability to:

  • Create liens;
  • Enter into sale and leaseback transactions; and
  • Consolidate or merge with, or sell, lease or convey all or substantially all of our or their properties or assets to, another person.

However, each of these covenants is subject to a number of significant exceptions. You should read "Description of the Notes-Certain Covenants" for a description of these covenants.

Digging deeper, we see the following:

Limitations on Liens

We have agreed under the indenture that we will not, and will not permit any Significant Subsidiary to, incur, issue, assume or guarantee any notes, bonds, debentures or other similar evidences of indebtedness for money borrowed (herein called "debt") secured by a pledge of, or mortgage or other lien on, any Principal Property, now owned or hereafter owned by us or any Significant Subsidiary, or any shares of capital stock or debt of any Significant Subsidiary (herein called "liens"), without providing that the Notes (together with, if we shall so determine, any other debt or obligations of Under Armour or any Significant Subsidiary ranking equally with the Notes and then existing or thereafter created) shall be secured equally and ratably with (or, at our option, prior to) such secured debt so long as such secured debt shall be so secured. The foregoing restrictions shall not apply to:

  • Liens existing as of the date of the initial issuance of the Notes offered hereby;
  • Liens on any property acquired (whether by merger, consolidation, purchase, lease or otherwise), constructed or improved by us or any Significant Subsidiary after the date of the indenture which are created or assumed prior to, contemporaneously with, or within 18 months after, such acquisition, construction or improvement, to secure or provide for the payment of all or any part of the cost of such acquisition, construction or improvement (including related expenditures capitalized for U.S. federal income tax purposes in connection therewith) incurred after the date of the indenture;
  • Liens on any property, shares of capital stock or debt existing at the time of the acquisition thereof, whether by merger, consolidation, purchase, lease or otherwise (including liens on property, shares of capital stock or indebtedness of a corporation existing at the time such Person becomes a Significant Subsidiary); provided that such lien was not created in anticipation of the Person becoming a Significant Subsidiary;
  • Liens for taxes, duties, assessments, governmental charges or levies that are not yet due or delinquent or which can be paid without penalty or are being contested in good faith;
  • Liens imposed for one or more Special Tax Districts;
  • Liens in favor of, or which secure debt owing to, us or any Significant Subsidiary; and
  • Any extension, renewal or replacement (or successive extensions, removals or replacements) as a whole or in part, of any lien referred to in the foregoing bullets, inclusive; provided that (NYSE:I) such extension, renewal or replacement lien shall be limited to all or a part of the same property, shares of capital stock or debt that secured the lien extended, renewed or replaced (plus improvements on such property) and (ii) the debt secured by such lien at such time is not increased.

Notwithstanding the restrictions described above, we or any Significant Subsidiary may incur, issue, assume or guarantee any debt secured by a lien which would otherwise be subject to the foregoing restrictions without equally and ratably securing the Notes, provided that at the time of such incurrence, issuance, assumption or guarantee, after giving effect thereto, the aggregate amount of all outstanding debt secured by liens which could not have been incurred, issued, assumed or guaranteed by us or a Significant Subsidiary without equally and ratably securing the Notes then outstanding except for the provisions of this paragraph, together with the aggregate amount of Attributable Debt (defined below) incurred pursuant to the first paragraph under the caption "- Limitations on Sale and Leaseback Transactions" below, does not at such time exceed 15% of our Consolidated Net Tangible Assets.

This is the "carve out".

Then we look at the definitions:

"Significant Subsidiary" means a Subsidiary of ours which owns or leases a Principal Property.

"Principal Property" means any manufacturing plant or other similar facility, office facility, warehouse, distribution center or any parcel of real estate or group of contiguous parcels of real estate located within the United States owned or leased by us or any of our Subsidiaries and the gross book value, without deduction of any depreciation reserves, of which on the date as of which the determination is being made exceeds 1% of Consolidated Net Tangible Assets.

Try to get a list of principal properties. You will normally hear silence on the other end of the phone if you ask.

(FWP - Term Sheet - This one can be found here)

Optional Redemption

The redemption price for notes that are redeemed will be equal to 100% of their principal amount, plus accrued and unpaid interest, up to, but excluding, the date of redemption, plus (ii) a make-whole premium (T+35 bps). If redeemed on or after 90 days prior to the maturity date, the redemption price for notes that are redeemed will be 100% of their principal amount, plus accrued and unpaid interest, up to, but excluding, the date of redemption.

The make-whole is the discount rate that will be applied when determining the redemption price of the bond. The lower the make-whole spread, the better.

Referring back to the prospectus, we get the definition of applicable premium:

"Applicable Premium" means, with respect to any Note on any redemption date, the excess of:

  1. The present value at such redemption date of the aggregate principal amount of the Note plus (ii) all required interest payments due on the Note through April 1, 2025 (excluding interest paid prior to the redemption date and accrued but unpaid interest to the redemption date), computed using a discount rate equal to the Treasury Rate as of such redemption date plus 35 basis points; over
  2. The principal amount of the Note.

When the covenant(s) for Under Armour and EPR are compared, it should be somewhat evident why we prefer the covenant package investors get from the REIT debt. Financial covenants in investment grade debt (ex REITs) are few and far between. As well, the reporting on covenant compliance is far better with the REIT than your typical investment grade credit (in this case, Under Armour).

Bottom line: REIT bonds have the attractive feature of financial covenants which help protect investors by limiting the amount of leverage a REIT can take on as well as helping to ensure that unsecured assets cover unsecured debt in case of a distressed situation. Reading the prospectus is an important piece of any analysis and can make a difference in hard times. Hopefully, this prospectus walk-through has been helpful.

Premium Service: We will be adding a REIT Bond section to our premium iREIT Investor service. We believe Bonds are an important asset class that complement our existing coverage of common and preferred capital sources within the REIT sector.

Author's Note: Brad Thomas is a Wall Street writer and that means that he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and I assure you that he will do his best to correct any errors if they are overlooked.

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended

Disclosure: I am/we are long O, DLR, VTR, HTA , STAG, GPT, ROIC, HCN, OHI, LXP, KIM, WPC, DOC, EXR, MYCC, TCO, SKT, UBA, STWD, CONE, BRX, CLDT, HST, APTS, FPI, CORR, NHI, CCP, CTRE, WPG, KRG, SNR, LADR, PEB, BXMT, IRM, CIO.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.