How Falling Interest Rates Affect Nontraded REITs
March 18, 2020 | Maria Smorgonskaya, James Sprow | Blue Vault
One effect that the recent fall in interest rates will have on nontraded REITs is the lowering of interest rates on variable rate debt. As of September 30, 2019, approximately 40% of all debt utilized by the nontraded REITs in Blue Vault’s Q3 2019 NTR Review was at variable rates. Typically this variable rate debt is in the form of a credit facility with a major bank, and the interest rate on the credit facility is tied to the London Interbank Offering Rate (“LIBOR”) or another interest rate such as the Prime Rate or Federal Funds Rate. For many nontraded REITs, the rates are based upon a 3-month LIBOR rate plus a spread, such as 250 basis points. If the variable borrowing rates are linked to another rate, such as the Prime Rate, the correlation between different short-term interest rates tends to be very high1.
Looking at the fall in the one-month LIBOR rate over the past several months, REITs with a substantial portion of their debt financing at variable rates should stand to benefit by lower interest expense. Shown below is the trend in the 3-month LIBOR rate since late December 2019.
For example, a nontraded REIT with all its debt at variable rates tied to the 3-month LIBOR rate might typically have the contractual interest rate reported as “LIBOR + 2.00%.” Using this example, a 100 bps drop in the LIBOR rate as we have observed since December 2019 would mean that the effective interest rate charged on the REIT’s variable rate debt would drop from approximately 4.00% annualized to 3.00% annualized. This would represent a reduction in interest expense for the debt of 25% when annualized, assuming the lower rate remains at that level for 12 months.
Those nontraded REITs that have a higher percentage of their debt at variable rates would benefit more from a drop in the reference rate for their debt. The greater the percentage of their debt at variable rates, and the lower the margin above the reference rate, the more the REIT could benefit from lower interest rate expense. In the above example, the margin of 2.00% plus LIBOR when LIBOR drops by 100 bps from 2.00% to 1.00% results in a 25% lowering of interest expense, other factors equal. If the margin above LIBOR is 3.00%, the resulting lowering of interest expense with the same drop in LIBOR is less, at 20%. Thus, the combination of the REIT’s percentage of debt at variable rates and the current weighted average interest rate on total debt can be used to estimate the savings in interest expense to be realized when the reference rate drops.
In the following plot, we illustrate a theoretical relationship between the percentage of debt at variable rates and the September 30, 2019, weighted average interest rates on the REITs’ debt as reported for nontraded REITs in the Q3 2019 NTR Review. The scatter plot shows the impact on the REITs’ weighted average interest rate on debt with a 100 bps reduction in the reference rate (3-month LIBOR for this example).
The greater the reliance on variable rate debt, the lower the REIT’s weighted average interest rate on its debt with the reduction in the reference rate. There is still a large amount of variability in the weighted average interest rate on debt for the REITs, depending upon a large number of factors including the portfolio asset types, the REIT’s creditworthiness and the maturity of the credit agreements.
It is also interesting to note that, prior to the recent steep drop in the reference interest rate, there was not a significant relationship between these REITs’ weighted average interest rates on their debt and the percentage of financing at variable rates. That is, on average, the weighted average interest rate for the nontraded REITs’ borrowings did not depend upon the percentage of the REITs’ debt that was at variable rates. Variable-rate debt and fixed-rate debt had roughly the same rates, on average across the sample (with much variation between REITs). But, with a large drop in the reference rate, and the drop in the variable rates that are linked to the reference rate plus a margin, a significant difference in the cost of debt at fixed rates versus the cost of debt at variable rates becomes evident.
Next, we look at how the drop in interest rates on variable rate debt might affect MFFO payout ratios. We calculate a hypothetical savings in interest expense for each REIT using the REIT’s percentage of variable rate debt, the REIT’s weighted average interest rate on that debt, and the REIT’s MFFO (modified funds from operations) through the first three quarters of 2019. Any hypothetical savings from lower interest expense would be expected to flow directly to the REIT’s net income and then to MFFO. As interest expense decreases, MFFO increases. The percentage increase in MFFO will depend upon the beginning point of MFFO prior to the decrease in interest expense. When MFFO is relatively high, a reduction in interest expense will have less impact on MFFO than it would if MFFO is relatively low. When MFFO is close to zero, reduction in interest expense can have an outsized effect, increasing MFFO by a large percentage.
The following table shows a hypothetical decrease in the MFFO payout ratio (MFFO/Total Distributions) for the nontraded REITs in the Q3 2019 NTR Review. It shows the hypothetical effect on the MFFO payout ratio if the interest expense for the first nine months of 2019 were reduced through a 100 bps reduction in the reference rate, such as the 3-month LIBOR.
Going forward, interest expense will be less for nontraded REITs that utilize variable rate debt, if the rates on such debt is linked to LIBOR or other interest rate indices, and if rates remain below those that were typical in 2019. This article provides a hypothetical look at how much that reduction in interest rate expense might affect an important metric like MFFO, and a ratio we use to evaluate the ability of a REIT to cover its distributions, the MFFO payout ratio. The lower the MFFO payout ratio, other things equal, the more likely that a REIT can sustain its distribution rates.
Of course, there are many other factors that affect a REIT’s ability to pay distributions and sustain distribution rates. The rates that REITs pay on their variable rate debt can be an important one.
1LIBOR, the Federal Funds Rate, and the Prime Rate tend to move together. Commercial banks quote the Prime Rate as the rate charged their most creditworthy corporate customers. While each bank quotes its own Prime Rate, the average tends to track the Federal Funds Rate plus a relatively unchanging spread. LIBOR is the most influential benchmark rate in the world. It is the amount banks charge each other for Eurodollars on the London interbank market. Since Eurodollars are a substitute for Federal Funds, the rate will track the Federal Funds rate closely.Go Back
I have been using Blue Vault Partners for the past five years. I have found them to be a valuable, unbiased resource when it comes to evaluating and comparing non-traded REITs. The reports help me analyze which sponsors are doing a responsible job of managing their offerings. This allows me to limit my REIT recommendations to only the most competitive products, and then track those REITs throughout their life cycle.