Unwinding the Debt that Binds

Office REITs take critical steps to deleverage and clean up their tangled balance sheets.

Office REIT stock prices hit rock bottom on March 6, down nearly 70% from their February 2007 highs, according to REIT consultant Green Street Advisors. Investors feared that the highly leveraged office REIT sector, faced with hefty debt maturities in an illiquid marketplace, did not have enough cash to weather the downturn.

Since the sector's early March lows, office REIT executives have been working overtime to repair their balance sheets with stock offerings and other equity-raising exercises. No fewer than 10 office REITs have announced common stock offerings since February. Among the bold moves:

  • New York office landlord SL Green Realty Corp. (NYSE: SLG) gained $57.5 billion from buying back $224.9 million of its unsecured notes at a discount. The REIT also raised $387.4 million through a stock offering of 2.5 million common shares.

  • Douglas Emmett (NYSE: DEI), which owns well-located office properties in West Los Angeles and Honolulu, bought back 605,600 of its common shares at an average price of $6.27 per share. By early June, the shares had jumped to $9.86. The company has roughly $2.6 billion in debt maturing in 2012, according to Green Street.

  • Brandywine Realty Trust (NYSE: BDN) raised $242.5 million when it issued over 40 million shares of common stock in late May. The office REIT has more than $1 billion in debt due through 2012, according to company CEO Jerry Sweeney.

Tough times ahead

For the past few months, investors have watched with approval as more and more REITs have taken measures to reduce their debt and squirrel away cash. This new confidence is manifested in the stock prices, which jumped nearly 50% for office REITs from March through the end of May.

But the industry isn't out of the woods yet. Now that the first round of deleveraging is well under way, investors are turning their attention to declining office fundamentals, which are expected to deteriorate as job losses mount. Moody's Economy.com projects the U.S. unemployment rate to reach 10.1% near the end of this year. Commercial office vacancies and rents, however, aren't expected to bottom out until early 2011.

“On the office side, we're fairly cautious,” says Tim Pire, managing director of real estate investment management firm Heitman, based in Chicago. “Office is probably going to be, from a fundamentals perspective, the sector that bottoms last in terms of overall cash-flow declines.”

Contrary to the oft-reported storyline that office REITs are building their war chests to take advantage of distress opportunities, at the moment deleveraging is the main focus, says industry veteran Barry Vinocur, CEO of REIT Zone Publications in Novato, Calif.

In fact, experts predict a tough and long row to hoe for office REITs and their investors. In today's volatile equities market, investors have a few more considerations to take into account when sizing up an office REIT, says Ralph Block, CEO of Essential REIT Publishing Co. and author of “Investing in REITs,” a book suitable for new investors.

Is the price right?

For starters, investors need to pay more attention to the specific markets in which a REIT's properties are located. “We've never had a situation where we've had such a wide range of local economic markets,” says Block. For instance, Phoenix does not share the same robust health as Washington, D.C. In metro D.C., the office vacancy rate for all classes of space was a tight 8.5% in the first quarter, while in Phoenix, where home foreclosures are rampant, the vacancy rate topped 20.6%.

Office REIT balance sheets, once largely conservative, are now of paramount concern to investors. Due to the quick and unexpected drop in commercial real estate values, many REITs are now highly leveraged. Green Street noted in a March 20 report that the average leverage for office REITs was 63%, weighted by market cap, compared with an average leverage of 56% for all REITs over the same period.

Although a REIT's properties might be performing well, the company could have maturing debt that can't be refinanced, which would then potentially force it to let go of high-quality assets at fire-sale prices, notes Block.

While office building values in the private market could ultimately drop by 40% from peak to trough, as many analysts predict, office REIT asset values on average have already dropped by 40% from their 2007 peaks, according to Green Street Advisors. “Clearly [commercial real estate] values are down,” Vinocur says, “but what people are missing is that REITs have already essentially factored that discount into pricing.”

REITs also are a forward-looking indicator and lead the broader property market by at least six months, according to an April 21 study by New York-based REIT investment firm Cohen & Steers. The reasoning is that the liquidity of REITs provides greater transparency in pricing and a faster transfer of information than less-liquid direct markets, according to Scott Crowe, global portfolio manager with the firm and co-author of the study.

If indeed office REIT stocks are now fairly valued, then the low-hanging fruit investors plucked from early March to late May when office REIT stocks jumped 50% isn't likely to reappear anytime soon, says Michael Knott, senior REIT analyst with Green Street Advisors. Rather than expect an upside on stock prices, investors itching to get into the sector should be content with dividend yields, which average about 7%.

“It's really difficult right now for a traditional REIT investor because it's hard to know [which metric] to look at,” says Block.

Historically net asset value (NAV) — which takes into account the value of a REIT's underlying properties — has been a mainstay metric to value REIT stocks under normal market conditions. But NAV may not be the best yardstick in today's economic environment. That's because transactions by dollar volume from May 2007 through May of this year plunged 96%, according to New York-based Real Capital Analytics.

Given that properties aren't trading, Block favors implied nominal capitalization rates, which show what kind of cap rates are being used to value a REIT stock at any particular point in time.

For instance, if a well-heeled REIT like Boston Properties had an implied nominal cap rate of 8.5% in today's market, but an investor believes the REIT should be trading at a 6.5% cap rate when the economy shakes out, the stock would be considered cheap, Block explains.

Office REIT investors seeking earnings growth are likely to be disappointed over the next couple of years, experts warn. As REITs make secondary stock offerings to pay down debt, funds from operations (FFO), a measure of REIT earnings, will be diluted.

Brandywine shovels debt

Despite its recent round of equity offerings, the office REIT sector is heavy with debt and needs to go on a crash diet. “The debt issue is still a concern for the office companies, but not for liquidity reasons,” says Knott. Going forward, he says, office REITs must continue retiring debt to reduce their average leverage ratio to around 40%. That's the level needed to optimize the REIT capital structure and to put the companies in position to take advantage of future opportunities.

Brandywine Realty Trust, whose leverage based on the total market value of its assets in late March was 75%, according to Green Street, has gone a long way. The Radnor, Pa.-based REIT owns, develops and manages a portfolio of primarily Class-A suburban and urban office properties totaling 37.3 million sq. ft.

Until Brandywine completed its offering of 40.2 million common shares on June 2, REIT experts expressed serious doubt about the company's ability to survive.

Prior to the secondary offering, Brandywine's stock sold for as little as $2 per share. By June 5, the share price rose to $7.34, still less than half of its 52-week high of $19.86. The company used the net proceeds of $242.5 million to reduce its unsecured credit facility to about zero, according to Sweeney, the company's CEO. Through 2012, the REIT's total maturities for both secured and unsecured debt are a little more than $1 billion, he says.

“We've made tremendous progress in the last five or six quarters and we've paid down over $700 million of debt [including the recent equity offering], which was a long way toward accomplishing our goal,” he says. Based on a different measure, debt to gross assets, Sweeney says Brandywine is now about 46% leveraged, from a peak of 55%.

With the debt markets essentially frozen, Brandywine, like other REITs, has not been able to rely on the bond markets to take out existing debt maturities. However, because the company has a large pool of unencumbered properties, Brandywine's capital plan now includes swapping equity for debt.

“The markets are very responsive to the companies that come out and say, ‘These are our maturities. This is what's going on and we're acting thoroughly to address it,’” explains James McLaughlin, senior vice president of KeyBank Real Estate Capital's structured real estate group.

Debt at a discount

“The worse off a REIT is the bigger the discount it can get on its debt. That's a smart thing to do, too, as long as it has the liquidity to do that,” says Block.

Brandywine, like many office REITs, also is buying back debt at a discount. Over the past three or four quarters, says Sweeney, his company has bought back $322 million in bonds at roughly a 12% discount.

“What that enabled us to do was go into the marketplace and buy our debt, which was trading at less than par,” Sweeney explains. “That enables us to retire debt early, and because of the discount on some of that debt we were able to effectively delever the company as well.”

SL Green has also drawn from that well. According to an April 27 company report, the REIT repurchased approximately $224.9 million of its unsecured notes this year, from which it realized gains of roughly $57.5 billion.

The company had been reluctant to issue new equity prior to its May offering of 2.5 million shares of common stock. “They thought the valuations were too low and the world had overly discounted the way everything was going to play out,” says Knott.

In the end, net proceeds from the stock sale, approximately $387.4 million, will help to remove the risk associated with the company's 2011 and 2012 debt maturities, about $1.8 billion and $547 million respectively, according to Green Street.

The cost to shareholders was high: SL Green chopped its quarterly dividend by 73%, to 10 cents per share. That was on top of a 52% cut at the end of 2008, according to analyst Todd Lukasik of Denver-based Morningstar.

Other REITs, like Brookfield Property Corp. (NYSE: BPO), are preserving precious cash by offering shareholders the opportunity to acquire additional common shares by reinvesting their dividends in lieu of cash payment.

Stick with the winners

The overarching advice to office investors is simple but worth repeating. “Be cautious: Get in with the right REIT, pick somebody with a good balance sheet and a good, safe dividend,” advises Pire of Heitman. “An earnings growth story is not a reason to do it because that's probably not going to occur.”

Which REITs are head and shoulders above the rest? Boston Properties, Douglas Emmett, Vornado Realty Trust, Mack-Cali Realty Corp., Duke Realty Corp., Highwoods Properties, Liberty Property Trust and Corporate Office Properties Trust are all members of the “good camp” of office REITs, according to David AuBuchon, senior research analyst with Robert W. Baird & Co.

“Those are the companies that have the appropriate capital structures, that are not going to run into issues with refinancing their business and the debt that comes due,” he says.

And finally, AuBuchon advises there's no greater commodity in the current downturn than patience. “That's what investors are going to need because it's going to be awhile before we see positive fundamentals.”

Sibley Fleming is managing editor.

Office REITs Rush to Market With Equity Offerings

As the economic tide has continued to roll out in 2009 laying bare the heavy leverage of office REITs, the sector has fought back with a historic wave of stock offerings to bolster their liquidity. Experts say these office companies will continue to focus on deleveraging to meet near-term debt maturities.

REIT/ Ticker Symbol Common shares offered (millions) Net proceeds* ($millions) Date priced
Digital Realty Trust (DLR) 2.5 $96 Feb. 10
Corporate Office Properties Trust (OFC) 2.1 $63 April 1
Duke Realty Corp. (DRE) 65.4 $480 April 16
Vornado Realty Trust (VNO) 15 $617 April 22
Washington Real Estate Investment Trust (WRE) 5 $102.6 April 30
Mack-Cali Corp. (CLI) 10 $239.1 May 1
SL Green Realty Corp. (SLG) 17 $336.8 May 12
Highwoods Properties (HIW) 6.1 $125.1 May 27
Brandywine Realty Trust (BDN) 35 $210.8 May 27
Kilroy Realty Corp. (KRC) 8.7 $166.7 May 29
** share offerings do not include underwriters' over-allotment option
Source: Company reports
TAGS: Office
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