On June 15, 2006, Standard & PoorÆs Ratings Services published an article titled ôGlobal REIT Market Moving Apace, As Ratings Convergence Anticipatedö. In an attempt to shed more light on issues affecting the sector and the rationale behind our ratings, we address below some of the most frequent questions we have been receiving since we published this article
Frequently Asked Questions
Throughout the globe, Standard & PoorÆs rated property issuers have ambitions to grow their portfolios with a mix of debt and equity. How has this appetite for growth manifested itself?
Investment decisions of REIT managers are made on calculated risk/return parameters. Property returns, both income and capital, are subject to cycles, and are largely influenced by local factors. However, in many global markets covered by Standard & PoorÆs, we are mindful of whether there are structural or cyclical events that are driving the current property cycle
Private equity funds have been valuing the future income streams from high-quality commercial assets more aggressively than the publicly listed REITs. These equity funds have introduced a structural shift in global real estate markets, driven primarily by their comfort in using a proportion of leverage, coupled with very attractively priced debt currently, along with their longterm investment horizons, a higher tolerance to withstand future income volatility, and a focus on capital appreciation. This asset inflation has spurred the more traditional buy-and-hold investors to trade assets and take advantage of recent property valuations, which are high by historical standards
While REITs have taken advantage of this selling frenzy to offload non-core assets from their portfolios, they have generally not been active acquirers, as they are unwilling to enter a bidding campaign and drive up asset values. With interest rates rising across the globe, Standard & PoorÆs believes that the cost of debt advantage will diminish and asset inflation will abate, allowing the REITs to re-enter the market as direct acquirers, utilising their robust financial capacity to grow
In response to this recent asset inflation some REITs have successfully teamed up with competing institutional buyers, via robust joint venture formations, to buy additional assets, earning very attractive risk-adjusted returns while controlling strategic assets
Why are managers increasingly looking offshore?
In an effort to diversify rent rolls and mitigate exposure to local property cycles, REIT managers are increasingly focusing on buying assets outside their home market. In some cases, REITs are venturing offshore to follow their tenantsÆ global aspirations, ensuring that client relationships are maintained. At the same time, some REITs are moving toward a geographically diversified portfolio to satisfy institutional debt and equity investors who are expanding their investment mandates outside traditional local markets. Furthermore, rising local real estate prices have tended to limit initial property yields, encouraging these REITs to enter offshore markets where yields are more favorable
Evidence shows that first-movers into new markets are able to gain a competitive edge. However, too often Standard & PoorÆs has witnessed ill-founded forays into unfamiliar real estate markets. Lend Lease CorpÆs failed and costly expansion into the US real estate investment-management market is a prime example. On the other hand, Standard & PoorÆs has witnessed successful forays into offshore markets, such as ProLogis (industrial properties throughout Europe and Japan) and Simon Property Group Inc.Æs acquisition of Chelsea Property Group Inc. (which provided Simon with the opportunity to expand ChelseaÆs wellpositioned portfolio of premium outlet centers in Japan). Inevitably, expansion into unfamiliar territories is doomed to fail if management are not confident that they understand the local property fundamentals and have appropriate staff equipped with local knowledge
Are property-management skills being reinvented?
Property management skills are being reinvented, even though many REIT managers still view their primary role as traditional long-term custodians of an asset portfolio. Under the traditional REIT model, management fees are derived from extracting maximum rental growth from an existing and acquired real estate portfolio. Managers of REITs have successfully taken property out of institutional/private hands and packaged a portfolio of solid income-producing properties. This ôbuy and holdö strategy holds great appeal to an institutional and retail investor base.
However, managers are increasingly looking to capitalise on their property skill base and apply this management expertise to areas not previously considered. Fund management businesses are being established within REITs to grow real estate assets under management. These businesses require minimal capital from the REIT while providing sizeable fee-income streams that bolster the managerÆs credentials. To retain key tenant relationships, managers are also increasingly procuring and managing the space needs of tenants. In-house development and construction of REIT assets has become another source of fee income that had been previously undertaken by thirdparty providers who assumed the risk of cost and time overruns on property development. A niche example of this strategy is the pursuit by some US apartment REITs of condominium conversions, although this activity to date has remained a modest contributor to these companiesÆ overall earnings. As REIT strategies evolve, the complexity in business structure and financial reporting could result in a reduction in the sectorÆs historically good transparency.
Does M&A activity remain a key rating factor?
The potential for further mergers and acquisitions (M&A) or go-private activity for the remainder of 2006 remains high, and is expected to be a catalyst for rating activity. REITs concentrated on the better-performing markets have attracted takeover interest, namely from private equity firms who can bear substantial debt loads and accept lower initial returns. Standard & PoorÆs would take a more negative ratings bias toward highly leveraged M&A transactions, which could lead to shift away from Standard & PoorÆs more favorable upgrade/downgrade ratio of recent years. In the established and mature markets of the US and Australia, the absolute number of REIT players has diminished due to substantial M&A activity. The remaining REITs have larger asset portfolios, more competitive business profiles, robust financing structures, and seasoned management teams
In the newly established REIT markets, each participant is rapidly setting out to establish a track record, amass a core asset portfolio, and prove to the capital markets that their operating strategy will outperform their peers. The merger frenzy that Standard & PoorÆs has witnessed over the past five years in the established markets will inevitably be a feature of the embryonic Asian and European markets. In particular, the high yield differential in these markets relative to the risk free rate will become difficult to justify in a higher interest rate environment. Volatility in global stock and bond markets since May 2006 has already delayed several Asian REIT listings. The debt and equity markets will eventually appropriately price in the unrealistic growth expectations from future rental returns, and the next cyclical downturn is likely to prompt further M&A activity as weaker competitors sell out
Will rising interest rates signal the end of the party for REITs?
Low interest rates have provided attractive debt funding opportunities for REITs to grow and, in some cases, helped offset weak operating results at the low point in the property market cycle. At the same time, sizeable capital flows to the global real estate sector have supported positive REIT equity returns. This steady flow of public and private investment capital continues to support property valuations, stable REIT bond spreads, and favorable REIT share price performances. At the same time, improving property fundamentals in most of the markets where Standard & PoorÆs rates entities has also contributed to the sectorÆs historical outperformance. For example, in Japan the heated market is testing the ability of REITs to manage the pace of asset growth in line with their investment guidelines
However, with interest rates now rising in markets across the globe, some uncertainty has emerged over the near-term outlook for the performance of, and investor support for, REITs. Property fundamentals have lagged behind asset price increases with capitalisation rates at unsustainably low levels. While a rising interest rate environment will pose a challenge to further stellar share-market returns, it should shake out marginal property investors and perhaps lead to a less overheated acquisition climate. As the cost of debt advantage diminishes and asset inflation recedes, the REITs will likely re-enter the market. Property yields will be affected by rising interest rates but they are also dependent on the REITsÆ ability to pass through rising costs in the form of higher rents. The amount of variable rate debt exposure a REIT has incorporated in its capital structure will also have a meaningful impact on how well certain credit metricsùsuch as debt service and fixed charge coverageùcan withstand rising rates
Are managers seasoned for a property downturn?
Local property cycles will vary in length and severity, and can cause market participants to react unpredictably. Our time horizon for issuer credit ratings extend as far as is analytically foreseeable. Accordingly, the anticipated ups and downs of the property cycle should be factored into the credit rating. In general, ratings are commonly held constant throughout the cycle, or, alternatively, stay within a relatively narrow band
Nevertheless, a worsening operating environment highlights the importance of a strong management team, a well executed strategy, and sound financial policies through the cycle. Indeed, an experienced management team and credible operating strategy are major determinants of our rating assessment. Wealthy private individuals and asset heavy corporates have been selling property holdings at historical peaks, spawning the rise of newly formed assetmanagement teams with overly optimistic operating strategies and an untested ability to weather a property down cycle. Although there has been more than a decade of sustained growth in the securitization of global real estate, many REIT management teams still may not have the depth of knowledge or the capacity to manage an asset portfolio through the next inevitable property downturn. Even so, within each of the jurisdictions covered by Standard & PoorÆs, there are clear market leaders with proven and effective acumen. Investors in jurisdictions that have a long track record of transparent property performance will support the stellar performers, and reward the better managers who wish to expand their asset and earnings portfolio
The managerÆs alignment with the interests of the REIT is a point of difference among the global players. Although Standard & PoorÆs does not explicitly favor the internal model over an external model in its credit ratings, regional distinctions have emerged. Internally managed entities in the US are the norm, driven by the reluctance by the equity holders to employ an external manager due to the potential conflict of interest. In the Japanese market, trusts are externally managed, given that these funds have been spun-off from the major property houses. The Australian model has adopted both structures. The remuneration of the manager is assessed by Standard & PoorÆs only when it adversely affects the financial metrics and impedes an alignment of interest. A welcome development in the global industry is tying remuneration to a fee based on earnings performance, rather than on asset growth
How does Standard & PoorÆs take into account regional differences?
Across the nine major jurisdictions analysed by Standard & PoorÆs, differing tax and accounting treatments influence the reported financial statements of REITs. However, there is a move toward more uniform accounts across major REIT markets. The most significant recent accounting change involves the transition to International Financial Reporting Standards (IFRS) in Australia, Hong Kong, and Europe. IFRS has introduced new financial reporting of the marked-to-market effect on assets and liabilities, how lease structures are recorded in the earnings statement, how tenant requirements and incentives provided are reflected, and the recognition of development profits. This move to IFRS reinforces Standard & PoorÆs focus on cash-based performance and prudential measures. As a result, it may change the behavior of REITs toward financing their asset ownership and growth platforms
The operating stability of REITs is affected by the common terms and conditions of the lease agreement. The rent renegotiation clauses, the term of the lease agreement, the recovery of outgoings, and the obligations at lease termination are unique to each local market. This highlights the lack of uniformity in tenancy agreements across regions. A rent roll that exhibits a short-dated leasing profile, with a mark-to-market rent review, will introduce a higher level of income volatility; such a scenario will be reflected in the performance measures, potentially limiting the credit rating. Fortunately, the major markets where Standard & PoorÆs has rated REITs possess well-established legal systems regarding land ownership, contract law, and lenders rights. Therefore, Standard & PoorÆs has a high degree of confidence that tenancy contracts will perform as expected and that dispute resolutions will be upheld
Standard & PoorÆs believes that market forces should determine the appropriate business strategies and financial profiles that real estate companies adopt. Ultimately, the relative performance of REITs will be judged and compared with their peers. Cashflow-based measures such as interestcoverage ratios more adequately reflect a real estate companyÆs debt-servicing ability than debt-to-asset limits based on market values, which are subject to the inherent volatility of real estate market valuations
In Singapore, for example, the Monetary Authority of Singapore has imposed a debt-to-assets cap of 35% on REITs that do not publish a credit rating. If a credit rating is maintained, REITs can exceed this threshold.
Interestingly, Singaporean REITs have sought ratings to appease the regulator, not for the purposes of raising debt in the capital markets. Standard & PoorÆs believes the limit imposed may restrict a managerÆs ability to operate under the cap, as real estate assets are illiquid in depressed markets and adequate balance sheet headroom evaporates.