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This is the second in a three-part series on REITs' debt. Previously, we looked at the increasing use of debt by REITs and its broad implications. Today we examine leverage by property sector with an eye toward which types of REITs can support more debt. We'll conclude the series with a look at silent debt, or unfunded and future obligations to which REITs have committed themselves, and a comparison between how private real estate companies and REITs use leverage.

Not all debt is created equal. Especially when you're taking about real estate: REITs' debt levels vary widely by type of REIT and operating strategy.

"Debt problems depend on the type of REIT," said

Sutro & Co.'s

Craig Silvers. "There are sectors that can operate fine at higher debt levels and those that should leverage lightly, especially in a weakening economy."

Overall, however, 1998 has been a year in which REITs have levered up, as they were forced to seek capital from the debt markets because issuing additional equity was not an option. For some, such leverage is benign. For others, it could prove to be the end of the line. (For a look at average leverage by property sector, see the table


So what determines whether a REIT has too much debt? The best analysts and money managers suggest looking at three factors: the length of leases, the quality of tenants and the state of the economy.

What Goes Up, Must Come Down

Which property sector is the most exposed to the economic cycle? The one that has the quickest turnover of its leased assets, of course, and that means hotels. Because their leases are the shortest in the business, they are the first to feel the pain from a slowing economy.

That sensitivity has been magnified over the past year as fears came to the fore that the sector had overbuilt at the very peak of the economic cycle. That spawned the downturn in many of the more highly leveraged lodging REITs, including

Patriot American

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. Why? Investors began viewing increasing levels of leverage as a foe in a slowing economy.

Many REIT pundits tout property sectors such as office and retail properties that have long-term leases as a way to protect property investments in a softer economy. "Longer leases provide protection against an economic downturn," said Silvers. Think of a high-end regional mall: With leases running 20 to 30 years, their cash flows are highly predictable, much more so than hotel REITs, which have to re-lease their property every night. Other sectors that have good long-term lease arrangements include industrial properties, office buildings and many of the strip-center and outlet-center retailers.

Quality Counts

While length of lease is important in determining safe levels of debt, so is quality of tenant mix, especially for retailers. "Retailers must carefully scrutinize their lease portfolios as they leverage properties against cash flows," said


Christopher Marinac. Several REITs found that out when Venture Stores (VENSQ:OTC BB), a major tenant, declared bankruptcy in 1997 and defaulted on many long-term leases.

"Quality tenants create quality cash flows," added

Cliffwood Partners'

Carl Tash. In the recent REIT

roundtable, Tash and Cliffwood's Melissa Shanahan suggested their best ideas were high-end retail REITs


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Urban Shopping


. Both have a high-quality mix of tenants and above-average sales per square foot. "Both Taubman and Urban will hold up well in a more challenging economy," Shanahan said. "Their debt levels are reasonable and their coverage is good."

Conversely, retail REITs with weak tenants or a less diverse mix may face problems if the economy heads south. "A retail REIT with 60% of its revenue from three tenants better have good tenants," Silvers said, adding that diversity is also very important. "When we go into recession, just how many cellular phone stores do you really think you need in a mall?" Several retailers that face debt challenges were featured in the

first part of this series.

The Multifamily Debate

Apartment REITs offer slightly different dynamics. "Multifamily REITs can take more debt than hotels," Robinson-Humphrey's Marinac said. "People have to have a place to live. While lease durations are shorter, the cash flows are much more predictible."

In fact, apartments can be a beneficiary of a slowdown. As consumers lose confidence in the economy, many put off the purchase of a new home, preferring to lease apartments in a price range close to the monthly mortgage payment they are contemplating.

Thus, the argument goes, upper-end apartment REITs may be safe havens in a recession. "History suggests that 'Class A' apartments are better off in an economic downturn," said Marinac, who recommends upscale developers like

Post Properties



Gables Residential


. (Robinson-Humphrey has a banking relationship with both companies.) "Upscale multifamily companies tend to have more pricing power and leasing certainty in a recession than do the middle-of-the-pack apartment REITs."

Not only do midrange apartment REITs offer less security from a quality standpoint, they also tend to have the most leverage. For example,

Lexford Residential


appears high on the list of REITs most in hock, as do

Tarragon Realty



Boddie-Noell Properties


. With higher leverage, lower coverage and less desirable property inventories, these REITs could suffer in an economic downturn.

Economic Reality Bites

While some analysts feel a reasonable "debt-to-asset value" suggests REITs aren't overleveraged, others aren't so sure, especially if the economy softens. That's because, some posit, the debt numbers don't take into account preferred-stock issues that create additional "stealth debt."

Those deals have soured the general market on real estate. "REITs clearly aren't listening to the markets," said Cliffwood's Tash. "If you're wondering why non-real estate capital is running away from REITs, it's because many REITs will do deals regardless of whether they make any sense."

The coming year may well see REITs on a diet. Already, several have begun to dispose of property, either out of necessity to meet current financial obligations -- like

Patriot -- or to reposition themselves around their core markets.

Only when that happens will investors return to the once-hot sector. In the meantime, for most, additional debt is not an option. They'll just have to learn how to ride out the bad times.

Time's running out. Time, that is, to send in your votes for the best and worst REIT stories of the year, and your picks for the year ahead. Shoot me an

email with your comments on the year in review for real estate and your best picks for 1999. We'll use them in an upcoming column. And, for the three best responses (chosen subjectively by yours truly!), a holiday gift courtesy of


that may appear on your doorstep just in the "Nick" of time. Happy building!

Christopher S. Edmonds is the president of Resource Dynamics, a private financial consulting firm based in Topeka, Kan. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. At the time of publication, the firm owned Starwood shares, though these holdings can change at any time. While he cannot provide investment advice or recommendations, he welcomes your feedback at