An Investigation of Current Debt Levels of Equity REITs
Oppenheimer, Peter H., Journal of Real Estate Portfolio Management
Executive Summary. This study investigates the current debt levels of equity real estate investment trusts (EREITs) and the ability of these companies to meet their interest and dividend payments. Critical financial ratios for the aggregate industry show that EREIT debt levels have consistently fallen since the recession of the early 1990s. In addition, lower debt levels and improved cash flows have reduced the risk of default as indicated by increasing debt coverage Levels. However, this trend significantly reversed in 1998 when the industry experienced sharp increases in debt and reductions in interest coverage ratios.
In 1998, the Federal Reserve Board (FRB, 1998) issued a supervisory letter to its examination staff and banking organizations that included a cautionary reference on unsecured lending to equity real estate investment trusts (EREITs). The concern resulted from member institutions reporting unsecured lending to REITs as commercial and industrial loans, which may not have fully recognized the underling real estate risk associated with the loans. Although the FRB stated that "on balance, the overall quality of loans being made has in general not changed significantly over the period, due in large measure to favorable economic conditions," they also stated that these favorable economic conditions could not continue indefinitely. The FRB feared that its member institutions' loan assets would lose value if the real estate industry suffered another contraction similar to the mid1980s. Yet, it was unclear from the FRB's comments whether EREITs have actually increased their debt levels. This article examines debt levels and coverage of debt and dividend payments for the period 1994 through 1998 for EREITs trading on the New York Stock Exchange. Findings show that debt levels significantly increased in 1998 from 1997, although most debt measurements still remain below recession levels. The increase in 1998 debt levels reversed declining trends in EREIT debt levels. In addition, the ability of EREITs to meet interest and dividend payments declined in 1998. Recent data from 1999 indicates that both equity and debt borrowing has declined for the REIT industry. To facilitate a thorough investigation of debt levels, EREITs were separated into groups based on property specialization and whether an EREIT began public trading before or after 1992.
Beginning in 1993, the EREIT industry experienced a significant increase in initial public offerings (IPOs) of EREITs and secondary stock offerings by existing EREITs. According to Ling and Ryngaert (1997), the relaxation of the Internal Revenue Code (IRC) five or fewer rule that in the past prevented institutional investors from purchasing large blocks of EREIT stocks helped fuel the growth of the industry in 1993. During this time, EREITs financed their growth from the sale of shares of stock. However, the equity markets have lately shown less interest in EREIT shares (Kirkpatrick and Templin, 1998). Consequently, EREITs in 1998 turned increasingly to debt to continue financing their growth and acquisition activities (Martinez, 1998).
Typically, publicly traded corporations have three basic methods for financing operations and growth: retained earnings (i.e., earnings after tax less dividends), debt borrowing (short or long term) and equity offerings (preferred and common stock). Yet, to avoid double taxation of dividends, federal tax laws require EREITs to distribute 95% of their pretax profits to shareholders as dividends. Hence, this reduces an EREIT's ability to finance growth through retained earnings.1 Also, it eliminates a potentially less expensive form of financing. Donaldson (1961) proposed a pecking order strategy that firms follow for financing their capital budgets. This theory suggested that firms first use retained earnings, then debt and finally equity for raising capital. The firms would base their order on the cost of the sources of capital, from lowest to highest. …