Co-produced with R. Paul Drake
In common parlance, a business is bankrupt when its liabilities exceed its assets. Any business that holds any debt and whose income drops enough for long enough can end up bankrupt. One can still go bankrupt without debt, but it is a lot harder.
In a more practical sense, what matters in the short run is solvency. Any business that can cover its expenses and make its debt payments is solvent. We discuss more nuances of solvency and being bankrupt below.
Figure 1. The major fear of stockholders and bondholders. Source.
Publicly-traded Real Estate Investment Trusts (REITs) are firms that own large quantities of real estate. By REITs, we refer to what are sometimes specified as equity REITs. Mortgage REITs (mREITs), a much smaller collection of firms, hold mortgages and are not our focus here.
The purpose of a REIT is not to make money by speculating on increases in real estate prices. It is to act as a landlord and make money from rents.
REITs are pass through entities. So long as they distribute 90% of taxable income to their shareholders, they pay zero corporate taxes.
This provides a significant level of security for REIT shareholders. The firm cannot decide arbitrarily to cut the dividend, even if they want to. If the REIT is making a profit, you the shareholder will get paid.
The resilience of REITs against bankruptcy follows from how they handle diversification and debt. We discuss these in turn.
REITs are diversified
Most REITs seek to specialize in one area of the economy (industrial, office, shopping center, data centers, malls, etc. etc.). The market has shown a clear preference for being able to decide to invest in one of these areas without others. Even so, a number of REITs are diversified across sectors. Examples include Gladstone Commercial (GOOD) and JBG SMITH Properties (JBGS).
Most REITs also seek geographic diversity and a diversity of tenants. These two aspects (diversity of geography and tenants) provide REITs with substantial resilience in hard times.
Figure 2 shows the locations of the properties owned by Kimco Realty Corp. (KIM), a shopping center REIT.
Figure 2. Locations where KIM holds property. Source.
In extreme downturns, the tenants of a REIT need not do well. So long as enough of them stay in business and pay their rent to cover its operating costs including interest on debt, a REIT will nearly always survive.
In actuality, the fraction of businesses that fail in recessions, even deep ones, is not large. Even in the Great Recession, all but one REIT continued to pay some dividends and came nowhere close to declaring bankruptcy.
A number of REITs were forced to cut their dividends during that period, but their share prices were not driven to zero and their dividends were restored as the economy recovered.
Figure 3 shows the dividend history. You can also see that REITs in some sectors, such as residential, cut dividends much less than those in others. In addition, as you research individual REITs, you will find the ones that came through with no dividend reductions.
Figure 3. Dividends paid by REITs, colored by sector. (mREITs are shown as the top band.) Source.
REIT debt is intermediate term
The second reason why REITs are resilient to bankruptcy relates to their debt structure. In almost all cases, the debt of REITs is interest-only debt.
The various debts require paying interest, which is a small fraction of operating costs, and have balloon payments when they are due. A key aspect of REIT debt management is debt refinancing.
At some point, you may have refinanced a house. Most likely you wanted a lower payment or money for college. But you probably also extended the maturity date of the mortgage. This aspect is key for REITs.
Any REIT with marginally competent management will seek to refinance its debt well before it is due. They show their existing creditors, or new ones, that their operations are profitable. They show that their physical assets are (typically) appreciating, but at least are worth far more than their depreciated value on the balance sheet.
The creditors typically agree to extend the debt for a few more years, at some interest rate. If they don't, the REIT has plenty of time to find new creditors, to sell bonds or equities, or to sell properties to raise funds.
Figure 4 shows how the debt structure of Uniti (UNIT), an infrastructure REIT. UNIT has been beleaguered by problems with a major tenant. Despite that, they rolled 2020 debt forward this summer without trouble.
Figure 4. The debt structure of Uniti REIT. Source: Uniti investor presentations.
One of the properties of a REIT is the weighted average maturity of its debt. They all show this. It is always several years or more. What this means is that an adequately managed REIT always has several years to address challenges related to paying its debts.
A few of the nuances
We will briefly mention a few nuances that help distinguish REITs that are extremely secure from those that are only very secure against bankruptcy.
Unsecured debt is good. Such debt makes no claim against any properties the REIT owns. The REIT is left complete flexibility in managing its assets. Simon Property Group (SPG) is just now floating more than $1B in 30-year, unsecured debt.
Unencumbered assets are good. These are assets not used as collateral for any debt. They can be sold or mortgaged in the future against need.
If debt is secured, it is generally attached to specific properties and these are encumbered. In this case, what is best is non-recourse debt. This means that the REIT can hand the property to the lender and walk away. (See Figure 5.)
Figure 5. The debt structure of STORE Capital (STOR) over time. Their unencumbered assets are nearly double their encumbered assets (The STORE Master Funding Asset Pool). Their loans on encumbered assets are non-recourse. Source.
Finally, much debt of REITs has debt covenants attached. These trigger consequences if various limits are violated and help assure that debt does not get dangerously large. For example, the REIT might be required to keep total debt below 60% of assets.
The reality of being publicly listed, and of having to answer to analysts in earnings calls, is that such REITs cannot hide from the above issues.
Most REITs are far from trouble on debt covenants and say little about them. For challenged REITs such as CBL & Associates (CBL), they are discussed more carefully. Figure 6 shows the relevant page from their August 2019 investor presentation.
Figure 6. CBL status regarding debt covenants. Source.
Cash flow matters too
You may have known a "technically bankrupt" 19-year old guy, who had run up credit card debt in excess of his assets but could make the payments because he had a job. Because of debt covenants, it is difficult for a REIT to get into this state.
The ideal condition for a REIT is to have enough free cash flow to pay off the debts if necessary, though likely at the expense of paying dividends that year. This enables the REIT to survive a financial crisis like that of 2009 when no one was willing to advance credit for any reason.
Store Capital is an example of such a REIT. STOR is a triple net lease REIT holding free-standing properties. It has annual free cash flow that generally exceeds current debt maturities. This insulates STOR from short-term problems with renewing financing.
More likely for a REIT is the case of a middle-aged fellow who loses his job. His house may be worth more than his mortgage, but he may not be able to lay his hands on the cash to make the payments.
Perhaps the real estate market has crashed too and it is unclear whether the house really can cover the mortgage. He may be forced to file bankruptcy to sort things out.
These kinds of risks are exacerbated by leverage.
REITs today carry on average much less leverage (ratio of debt to assets) that they did 20 years ago. The average is about 35%, down from 55%. This allows a lot more leeway to refinance loans, even in down markets.
At High Yield Landlord, we prefer the ratio of loans to asset value as a leverage metric and evaluate it for REITs we recommend. We explain why here.
The exception that proves the rule
Let's return to that definition of bankruptcy. The value of assets, save for straight cash, is never certain. The price you can get for your house, if you must sell it in one day, differs from the price you can get if you can wait for the right buyer or the desired market conditions.
So, if a REIT had high leverage, at a time when the market for real estate had become uncertain, and the credit markets were frozen or nearly so, then that REIT could reach a state where creditors were unwilling to advance the credit needed to roll forward the debt that is due.
In nearly 4,000 REIT years of operation, only one REIT (we believe) has reached this state and was forced to declare bankruptcy. So, if you are statistically minded, the odds for any one REIT to fail in any one year are with some factor of 0.025%.
The failure was that of General Growth Properties (GGP). Their case was discussed in an article by the High Dividend Opportunities authors earlier this year.
GGP was massive and had been expanding rapidly. Their debt was 80% of their real estate at cost. For comparison, CBL today is at about 60% and is the most leveraged mall REIT.
The GGP cash flow was barely able to cover their interest payments and their debt maturities were substantial. In the context of their discussion above, they managed their debt maturity structure poorly. Figure 7 shows how front loaded and large their debts were.
Quoting the article:
In 2008, GGP was unable to roll their mortgage debt. The loan-to-value ratios were too high in a market where lenders were tightening up, while occupancy and property level net operating income was declining.
GGP was still able to access some capital. In 2008, GGP was able to issue $822 million in equity in March and they were able to refinance $838 million of their 2009 mortgage maturities. It was a losing race as they did not have any significant unencumbered collateral and were already heavily leveraged. GGP's lack of flexibility was the main catalyst for their bankruptcy.
The nail in the coffin was the $400 million in bonds that matured in March 2009. Since they had defaulted on their senior credit facilities, GGP needed the bondholders to agree to forbearance. The vote failed and GGP was headed into bankruptcy.
In many bankruptcies, the shareholders lose everything. In this case, they were paid a small dividend during the bankruptcy proceedings, required for GGP to maintain REIT status. They then ended up with one share per share in a new GGP and partial shares in another new firm, Howard Hughes Corp. (HHC).
Figure 8. GGP stock price vs time. Source.
As Figure 8 shows, during 2010, the price of the new GGP rose above the price or GGP before 2003. It climbed further into 2018. Dividends were resumed after 2010 and paid nearly all the time.
Eventually, the new GGP was bought out. Those who bought during the crazy, debt-fueled expansion lost value. Investors who bought early and held on through everything did well enough.
On the whole, GGP was a viable business and ended up in bankruptcy thanks to bad luck on top of poor management decisions.
The REIT at risk today: CBL
There is an active and ongoing discussion on Seeking Alpha, and also in our chat room at High Yield Landlord, concerning whether or not CBL will end up forced to declare bankruptcy in 2023.
CBL holds many dominant malls in secondary markets. Large numbers of department stores have failed. CBL is spending all the money they can lay hands on to re-purpose those spaces.
The debt maturity structure of CBL does not look so bad (Figure 9). But CBL stacks up poorly by the standards discussed above. They have few unencumbered properties and not a lot of non-recourse debt.
Figure 9. CBL debt maturities. Source: August 2019 investor presentation.
If they do not show enough progress within four years and if they don't take other actions, the creditors will get to decide and CBL might be forced into bankruptcy. This could potentially happen sooner if they mismanage, their debt relative to their covenants.
We are optimistic but far from certain about the ultimate fate of CBL. They are transforming their malls into diverse community centers, very different from the retail-only oriented malls of the past.
Without question, CBL is a highly speculative investment today. Success or bankruptcy, however, are not the only choices. Most estimates of the value of the CBL properties believe that the company has substantial net value.
What happens instead of bankruptcy, for troubled REITs, is often liquidation. The shareholders often, but not always, do well. This will be the topic of a next article.
Portfolio implications
The chance that any REIT you invest in will go bankrupt is tiny. This is triply true if you stay away from REITs with:
- high leverage
- high fractions of their property subject to encumbered debt or recourse debt
- cash flows [technically Funds From Operation ("FFO") or Adjusted FFO] that do not amply cover the interest they must pay
- covenants that are at risk of being violated.
Added safety is to be found by diversifying across multiple REIT sectors. Even in a down economy, they all do not suffer equally. In particular, residential and apartment REITs, shopping center REITs, hospital REITs, and self-storage REITs are good defensive sectors.
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