REITs are companies that buy, develop, manage, and sell real estate assets. One special feature of REITs is that they qualify as passthrough entities and are therefore free from taxation at the corporate level.
REITs must comply with a number of Internal Revenue Code provisions to qualify for that tax-free status. In particular, REITs must pay divi- dends equaling at least 90% of their taxable income, and more than 75% of total investment assets must be in real estate assets. Their major business activity is the generation of property income, and no more than 30% of gross income can come from the sale of real estate property held for less than four years. So they are clearly “buy and operate” entities, not flippers or traders.
REIT Taxonomy
REITs fall into three broad categories: equity REITs, mortgage REITs, and hybrid REITs.
Equity REITs are the dominant category, representing about 95%
of total market capitalization. Their revenues are derived principally from rents. Equity REITs invest in and own properties (and are thus responsible for the equity or value of their real estate assets). Equity REITs differ by specialization. Some focus on a specific geographic area (a specific region, state or metropolitan area), others focus on a specific property type (such as retail properties, industrial facilities, strip malls, office buildings, apartments or health care facilities). Still other REITs have a broad focus, and invest in a variety of assets across a wide spec- trum of locations. The most important asset holdings are retail proper- ties, residential properties, and industrial offices.
Mortgage REITs represent between 3% and 4% of total REIT mar- ket capitalization. These REITs provide mortgage money to owners of real estate, and purchase existing mortgages and mortgage-backed secu- rities. Their revenues are generated primarily by interest they earn on the mortgage loans. Mortgage REITs have become a considerably less important part of the market over time. In 1990, they had represented about 29% of total REIT market capitalization.
Hybrid REITS represent less than 2% of the market. They combine the investment strategies of equity REITs and mortgage REITS by investing in both properties and mortgages.
130 STRUCTURED FINANCE CDOs AND COLLATERAL REVIEW
Mortgage REITs are rarely used in CDO deals. CDO managers are interested exclusively in equity REITs. This is because recovery assump- tions for mortgage REIT debt are much more stringent than for equity REIT debt. In SF CDO deals, recovery assumptions are dependent on the bond’s percentage representation of initial capital. Recovery rates on typi- cal subordinated CMBS/ABS/MBS assets are 30% to 35%. For equity REITs, Moody’s assumes a recovery rate of 40%, which reflects the strong covenant packages that we will discuss later. Thus, assumed recovery rates for equity REITs are very similar to those on subordinate CMBS/ABS/
MBS assets. By contrast, on health care REITs, which carry special risks due to significant government regulation of their ownership and opera- tion, and mortgage REITs, which tend to be highly leveraged, Moody’s assumes only a 10% recovery rate.
REIT Capitalization
The REIT capital structure consists of secured bank loans, unsecured debentures, preferred stock, and equity. Because an equity REIT can buy and sell assets and change financial ratios, debt covenants are one of the most important protections available for holders of unsecured REIT debt.
Here we look more closely at REIT debt covenants, and learn how minimum ratios compare to those on CMBS. We will find BBB rated REIT debt has ratios very similar to single-A rated CMBS debt. We will also learn that, in practice, REITs hold ratios even much higher than those provided by the covenants.
REIT Debt Covenants
Investors in REIT debt will find the covenants quite significant in provid- ing protection. Standard covenants are shown in Exhibit 5.2. A typical REIT covenant package includes the following:
1. Total debt cannot exceed 60% of total assets.
2. Unencumbered assets must represent at least 150% of unsecured debt.
3. Secured debt cannot exceed 40% of total assets.
4. Interest coverage must be greater than 1.5×.
While these look very different from levels that mortgage market junkies are accustomed to, they are easily translated. In fact, they parallel very closely A ratings for CMBS. Let us look of each of these more closely.
The debt/adjusted total assets ratio is very close to an LTV in the CMBS market: It measures the value of the loan versus the value of the property. This ratio must be no more than 60%. In fact, for single-A rated CMBS debt, the implied LTV is generally in the range of 60% to 65%.
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Generally in a CMBS conduit deal, total LTV is 75%. However, approxi- mately 15% of the deal is subordinated to the single-A tranche, so we can multiply the LTV on the deal by 0.85. This gives 64% LTV (0.75 × 0.85).
The total unencumbered assets/unsecured debt ratio must be at least 150% in a REIT. This leverage ratio is actually a very close relative of LTV measures used in CMBS. It says that unsecured debt cannot be more than 66% of total unencumbered assets. Again, these levels are very similar to the LTVs for single-A rated CMBS debt.
The next ratio is secured debt/adjusted total assets. Since REIT debt is senior, but unsecured, this ratio measures the percent of debt ahead of the bondholder in a REIT capital structure. That ratio must be no greater than 40%. In a CMBS deal, there is approximately 25% subor- dination under the AAA. The AA and A are generally about 5% each.
So the single-A rated CMBS bond has 80% of the deal ahead of it. Thus, the BBB rated REIT has a much lower percent of the deal with a prior claim on the assets, which provides a heavy measure of protection.
The final ratio, consolidated income available for debt service/annual debt service, is very close to a debt service coverage ratio (DSCR). This measures how much income cushion there is to pay bondholders the interest due them. This ratio must be at least 1.5× on a REIT deal. For a single A class on a CMBS deal, it is right around the same level. That is, the deal typically has a 1.25× DSCR at the whole loan level. With 85%
of the deal senior, or pari passu, to the single A (15% subordination), we obtain a DSCR of 1.47× (1.25/0.85) on the single A CMBS.
Reasons for Tough Ratings
The minimum covenant restrictions for BBB rated REIT debt are very close to the ratios that are required for a single-A rating in the CMBS market. Moody’s acknowledges this by saying “REIT ratings tend to run several grades lower than commercial mortgage backed securities (CMBS)
Covenant Ratio CMBS Ratio
Debt/Adjusted total assets No more than 60% LTV Total unencumbered assets/Unsecured debt At least 150% LTV
Secured debt/Adjusted total assets No more than 40% Percent of debt that is senior Consolidated income available for debt ser-
vice/Annual debt service
At least 1.5× DSCR
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ratings for pools with comparable asset classes and financial ratios.”3 The reasons for the tougher grading scale for REIT debt are fourfold.
■ REITS may substantially alter the composition of their portfolio assets unlike a CMBS, which involves fixed pools. So REIT assets can be pur- chased and sold, while CMBS assets can only leave the pool, and none can be added.4
■ Financial ratios of a REIT can change over time, but the capital struc- ture of a CMBS is permanent. REIT covenants typically allow signifi- cantly greater leverage than the capital structure currently in place.
This gives REITs more financial flexibility, but could jeopardize bond- holders.
■ REIT debt is unsecured, whereas first mortgage positions of CMBS are secured.
■ And finally, REIT debt is in the form of bonds, while most CMBS debt is in passthroughs. Thus the REIT debt must be paid in full on a spe- cific day, which is a more stringent hurdle than that for a passthrough completing payment by a stated final maturity.
Investors should realize that not only are covenants in a REIT extremely conservative, but most BBB rated REITs have ratios far more conservative than what covenants actually permit.
Reasons REITs Are Included in CDOs
REITs have become a very important part of structured finance CDOs, comprising 10% to 50% of total assets on a number of deals. REIT debt is included because:
■ REITs do not have negative convexity and hence help minimize the negative convexity for the CDO.
■ REITs provide valuable diversification for CDO deals.
■ REIT yields are somewhat higher than CMBS yields for assets with similar ratings.
Minimizing Negative Convexity
REIT debt generally has 10 to 12 year final maturities and excellent call protection. The call protection occurs because the securities are noncall- able bullets or have yield maintenance provisions. The yield mainte- nance provisions (or “make whole” provisions) are very similar to those
3 See Moody’s Investors Service, “Credit Rating Evaluation of REITs” (December 9, 1994).
4 In a FASIT structure, substitutions are permissible.
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Calling yield maintenance deals usually represents a windfall to the investor.
To illustrate, assume an investor hypothetically purchased a new par REIT bond, with a 10-year maturity and a coupon of 8.35%, selling exactly at par. (Also assume that the 10-year Treasury note is 5.85%, implying the REIT debt has a spread of 250 bps to the 10-year.) If the bond is called immediately, its value (at a Treasury plus 25 basis points discount rate) is $116.66. Thus, investors receive a $16.66 windfall. If interest rates have fallen, the value of the bond is even larger. In prac- tice, this means that REIT debt is rarely called. It is totally noneconomic to refinance, as bondholders receive more than the savings from any refinancing following lower rates.
This call protection is important because both residential, mort- gage-backed securities and mortgage-related ABS have some amount of negative convexity. The convexity problem is minimized in any CDO by limiting the amount of negative convex paper in that deal. Thus the deals must use a heavy component of nonmortgage-related ABS paper, CMBS paper, and REIT paper.
Diversification
REIT paper provides valuable diversification for CDO deals. CDO rat- ings are derived by reducing the asset pool to a set of nearly homoge- nous, uncorrelated assets. Structured finance-backed CDOs generally have much lower diversity scores than do high-yield CDOs, since there are substantially fewer categories. On a structured finance deal, a typi- cal diversity score is 15 to 20, compared to the typical 50 to 60 on a high-yield deal. So for convexity purposes, it is important to include nonmortgage-related assets, as well as CMBS and REITs. However, availability of nonmortgage-related subordinated tranches is very lim- ited, and Moody’s has only three CMBS categories. By contrast, there are 8 REIT categories, as shown in Exhibit 5.3. Thus, REITs turn out to be a very valuable source of diversification for CDO deals.
Some Yield Pickup to CMBS
Investors are able to obtain this diversification and collateral availabil- ity advantage without giving up yield. In fact, REITs actually yield more than do comparably rated CMBS.
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EXHIBIT 5.3 Moody’s Industry Classifications
Source: Moody’s Investors Service, “The Inclusion of Commercial Real Estate Assets in CDOs,” October 8, 1999.
One would think that with such conservative rating methodology on ratios, REITs would tend to trade tighter than CMBS. In fact, the reverse is the case. REITs tend to trade wider at each rating level. Indus- trial and residential REITs generally tend to trade 5 to 10 basis points wider than equivalently rated CMBS debt at the BBB and BB levels.
Retail/storage REITs tend to trade about 30 to 35 basis points wider.
A number of investors have expressed frustration that REIT spreads do not follow the same patterns as those on other corporate bonds. In fact, REIT debt tends to track CMBS debt very closely in the BBB cate- gories.
A Final Advantage
In addition to giving managers a wider choice of available assets, we have argued that REITs add diversification to CDO deals. We also have explained that REIT covenants are approximately as conservative at the BBB level as are CMBS ratios at the single-A level. Moreover, most REITs tend to have actual financial ratios far more conservative than what their covenants allow. The final advantage stems from the fact that REITs are actually wider in yield than comparably rated CMBS debt. In short, REIT exposure should be looked at as a “plus” within the context of a structured finance REIT.
Industry Classifications Category CMBS
Conduit 1
Credit tenant leases 2
Large loan 3
REIT
Hotel and leisure 4
Residential 5
Office 6
Retail 7
Industrial 8
Health care 9
Diversified 10
Self Storage 11
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CHAPTER 6
135
Review of Structured Finance Collateral: Nonmortgage ABS
e continue with our review of structured finance collateral in this chapter. Here we cover credit card receivable-backed securities, auto loan-backed securities, student loan-backed securities, SBA loan- backed securities, aircraft lease-backed securities, franchise loan-backed securities, and rate reduction bonds.