REITs have been enjoying this historically low interest rate environment which affords rapid expansion and greater spreads, but what happens if the Fed raises interest rates? In such a scenario, the outlook for various companies differs materially so it behooves us to be able to predict trajectories. While other factors will undoubtedly affect a company's success, we can say cleanly and certainly how interest rate changes, as an isolated variable, will qualitatively influence a company.
As we already know, borrowers with fixed rate debt tends to perform better in the event of the Fed significantly increasing interest rates. Consequently, investors may look at fixed to variable rate debt ratios to determine a company's outlook in such a scenario. While this will generally be true, we can gain a deeper understanding and a more accurate view of potential risk by studying the intricacies of debt. We will begin by examining various financing tools, and follow with Simon Properties Group (SPG) as an example of company trajectory as it relates to interest rate changes.
Fixed rate debt, from a changing interest rate perspective, can be thought of as an option. The company is willing to pay vastly higher interest rates in the near-term for potential long-term benefits. It only becomes "in the money" when interest rates are raised sufficiently high and must have enough duration left such that the magnitude of savings after the increase outweighs the spread between it and its variable rate counterpart in the interim. Fixed rate debt comes in various forms, each having their own benefits in different interest rate environments:
· Bonds and other term loans: these can usually be obtained at superior rates to other forms of debt, but have the downside of being recourse and of a set duration.
· Preferreds: While typically at higher rates, around 6%-7% currently (depending on the company), preferreds come with the benefit of counting as equity which improves debt to equity ratios and increases compliance with various covenants attached to other debt of the company. Also, the infinite duration could really pay off if the Fed increases interest rates significantly.
· Mortgages: As non-recourse debt, mortgages are less detrimental to shareholders in the event of liquidation, but the encumbering of the associated building makes disposition more difficult. Some companies cross-collateralize multiple assets to enhance the size or rate of the loan. Mortgage loans of long duration would fair very well as interest rates increase.
Variable rate debt is often viewed as being riskier, but in reality it is simply a different risk. What makes it more frightening to the market is that the magnitude of potential loss is unknown, as opposed to fixed rate debt where there is a maximum loss in comparison to the variable rate counterpart. However, the fear is in many cases unjustified as there are several subtle mitigations to said risk.
· A short loan duration provides an opportunity to refinance with minimal time spent paying high interest rates in the event of an increase. While a new loan would be at unfavorable rates, the loan coming due could be paid off through equity offering, disposition of an asset, available capital resources, or loaded onto the credit facility to be paid off through cashflows.
· Longer term variable rate debt can also have escape mechanisms built in such as prepayment clauses and/or ceilings.
With this sort of examination, we can get a very clear picture of how different debt structures play out in various scenarios. Simon Properties Group has a particularly interesting debt profile.
Type of Debt
Balance as of 6/30/12
Weighted average interest rate%
This debt structure is an excellent example of how SPG is well prepared for any interest rate scenario. The heavy weighting toward fixed rate debt protects from increases, while having over $2B drawn on their LIBOR + 1% credit facilities takes advantage of the present environment. The largest concern comes in its debt maturity schedule:
With over half its debt coming due between 2015 and 2017 it may have trouble refinancing favorably if interest rates are high at that time. However, SPG is making great progress in smoothly laddering their newer debt so as to lock-in low rates for a long time. For example, on March 30, SPG issued the following senior unsecured notes:
Fixed interest rate
Rates this good are rarely seen in the REIT world and are comparable to the famously successful 2.375% 10 year bond recently issued by Volkswagon (VW.SW). SPG further strengthened its debt structure through an at par redemption of $124.9mm of senior unsecured notes with coupons ranging from 5.75% to 6.88%. As the largest REIT, and with a strong balance sheet, Simon Properties can really throw its weight around to get some truly superb financing. It has already made great progress and will continue to refinance at advantage. Expect to see its debt maturities further laddered as well as a decreased weighted average interest rate in the near future.
While there has been little to suggest an impending interest rate hike, it becomes increasingly important to understand the effects of interest rate changes as we exit the recessionary environment. SPG seems to be well prepared for any scenario, but other companies may present large risk. Awareness of such contingencies affords choosing some riskier stocks if we can know precisely what we are getting into.
Disclaimer: This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.