The Use of Debt in Nontraded REITs

Virtually all nontraded REITs utilize debt to finance property portfolios. There are many reasons cited by nontraded REIT sponsors to finance investments in commercial real estate with combinations of equity raised through their public offerings and debt obtained in the form of mortgages secured by the REIT’s assets. Following are some of the key reasons sponsors use to justify the use of debt financing:

• Leverage (debt financing) increases investor returns when the cost of debt funds is lower than the capitalization rate (annual operating income as a percentage of the asset value). The spread between the cost of funds and the capitalization rate represents a potential gain to shareholders.
• By enabling the REIT to acquire more assets per dollar of shareholder investment, debt financing allows the REIT to increase its scale and achieve greater economies of scale, spreading the fixed portions of general and administrative expenses over a larger asset base.
• REITs can obtain debt financing at a lower cost of funds than individual investors due to the variety of sources available, including money-center banks and capital markets.
• REITs can utilize interest rate swaps and caps that effectively convert variable rate debt that is available at lower cost than fixed-rate debt to fixed-rate debt.
• By increasing the size of the real estate portfolio, debt financing also allows greater diversification of the portfolio’s assets, both geographically and by asset type.
• For REITs that invest in debt instruments, matching the maturities of debt financing with the maturities of the debt assets can mitigate interest rate risk and refinancing risk.

Of course, the potential advantages of using debt financing for commercial real estate portfolios are not without risks. For example:

• Interest payments and debt principal due can limit the cash flows available to make distributions if operating income is not sufficient over time to fund both. Debt obligations will always have priority over shareholder distributions.
• If re-financing is required, favorable rates may not be available depending upon the macroeconomic environment and the performance of the REIT’s assets.
• In worst-case scenarios, a REIT may be forced to liquidate a portion of its portfolio to meet its debt obligations, and in market conditions that are likely to be depressed.
• Potential conflicts of interest between REIT advisors and shareholders can arise if using debt to finance larger portfolios is motivated by increasing asset management fees or other fees based on assets under management, real estate transactions or financing arrangements.

Investors can use Blue Vault nontraded REIT reports to assess the use of debt by each REIT. The reports break out the debt by fixed or variable rates as well as the principal due over the next five years. High percentages of variable rate debt in the REIT’s financing and significant portions of the REIT’s debt requiring repayment in the next few years indicate the REIT’s interest rate risk and need for refinancing. Another metric which investors can use to assess the REIT’s ability to successfully fund its debt obligations is the Interest Coverage Ratio which measures the margin of safety between the REIT’s operating cash flow and its interest expense obligations.

The REIT’s weighted average cost of debt is another indicator of its ability to successfully use leverage to enhance shareholder returns. While a lower weighted average cost of debt may, at first glance, appear to give the REIT a healthy margin between its return on real estate investments and the cost of using financial leverage, investors need to be aware that:

• Short-term financing is typically obtainable at lower rates than long-term financing, via bank lines of credit, but must be refinanced eventually with longer-maturity debt.
• Unless variable rate debt is effectively hedged via swap contracts or interest rate caps, the cost of the REIT’s debt may rise significantly when market rates rise.
• The REIT’s debt ratio as measured by the book value of its debt as a percentage of the book value of its assets according to GAAP (Generally Accepted Accounting Principles) may be considerably lower when measured using the market values of both assets and debt.
• When real estate assets are depreciated on the REIT’s books each year, the debt ratios may appear to increase based on GAAP, but loan-to-value ratios may be falling.
• The use of debt financing will vary across asset classes. Expect to see higher debt ratios for apartment REITs than for data center or healthcare REITs, for example. Collateral differences may determine the optimal use of debt, depending upon asset types.
• As nontraded REITs move toward maturity and eventual liquidity events, expect the REIT to restructure its use of debt to facilitate either liquidation or assumption of debt by a merger partner.