The anatomy of a rating

Two top Moody's executives explain how the credit rating agency "grades" some of the world's biggest companies.

The credit ratings issued by Moody's Investors Service carry a lot of clout. If a real estate company's credit rating slips, it may have difficulty obtaining financing for future projects. Given Moody's influence, it's no surprise that companies take these grades very seriously. Two of Moody's top finance analysts recently took time out to discuss the rating process, focusing on long-term debt rankings. John Kriz, managing director of Moody's Real Estate Finance team, and Lesia Bates, vice president/analyst of the division, discussed issues ranging from the purpose of Moody's ratings to how committees reach consensus on these grades.

The New York-based credit rating agency started in 1909 when John Moody published a book analyzing railroad investments. Since its incorporation in 1914, the company has expanded across the globe, opening offices in many of the world's most important business centers, including Tokyo, London and Hong Kong. The company now provides ratings and information on both commercial and government entities in 100 countries.

Q: What is the purpose of a Moody's rating?

John Kriz: Ratings are most commonly used by companies, governments and others that are interested in tapping the securities markets for funding. Most commonly, this in the form of public bonds, medium-term notes or preferred stock, but it can also include private placements as well as bank loans.

Folks also use credit ratings for any number of reasons beyond just as a basis to make securities investments. For instance, there are partners who are interested in the credit worthiness of their partners.

Q: How about REIT and real estate operating companies, in particular. What would be their interest in a rating?

John Kriz: Most commonly it's to help them place bonds, medium-term notes, bank loans, preferred stock or other securities. We also have issuer ratings on companies, which are best seen as generic ratings on the senior obligations of a firm. Those issuer ratings have proved useful to firms, particularly firms that may not fund very much in the public markets but still have a need for a well-regarded public statement of their credit worthiness.

Q: Can you describe some of the different ratings?

John Kriz: We have issuer ratings, which are ratings on companies, and speak to their general ability to meet their senior obligations. We have ratings on very specific types of securities. Those ratings can vary, depending on the security. We rate bank loans; we rate bonds, preferred stock and commercial paper. We also assign financial strength ratings to banks. There are many credit ratings that speak to the different needs of the investing community.

Q: When does Moody's review a REIT or a real estate operating company to make an initial rating?

Lesia Bates: Most often companies are anticipating issuing debt or some security in the marketplace, so they would come to us and ask us to rate securities. This gives them a sense of what the capital pricing would be on the securities if they were to execute in the marketplace.

Q: When does Moody's revise a rating?

Lesia Bates: There is an ongoing monitoring process. So to the extent that a company either changes its strategic focus or is perhaps making an acquisition to expand into a market in which it does not have an established track record or expertise, Moody's would review a rating. Those broader transactions generally cause us to take a long, hard look at the company. We may adjust a rating based upon the implication such a transaction has either on the balance sheet or the competitive standing of the company.

Aside from revising a rating based upon those types of transactions, we continue to monitor ratings on an ongoing basis, and you may have situations where perhaps there's not some transaction in-and-of-itself that's prompting us to revise the rating. It may be a more long-term process, looking at certain trends in the company. Let's say leverage, for example, continues to increase due to the company's financing strategy of using more debt. That may cause us to revise a rating. Changes in the macro-market environment or micro-market environment also could prompt us to take a second look at the rating as well. First and foremost, if there is some major transaction that could positively or negatively impact the operating or financial profile of a company, we would make a change in the rating.

Q: Let's take a hypothetical REIT. How does the rating process begin?

John Kriz: Here's a fairly generalized case: A company might give us call to indicate it is interested in getting a rating. That relationship would be assigned to one of our senior analysts, who would be the main point of contact between Moody's and the company. The analyst and the appropriate official from the company, generally the chief financial officer, would have a conversation regarding the precise needs of the firm as well as the timing of those needs, and begin to make arrangements to get the process going. At that point, we would make some initial informational requests of the company for items such as annual reports, descriptions of the properties, and so forth, as a way to help us become familiar and current with the company. Once we had a chance to review those documents, we would then share with the company a more detailed list of information we would find helpful, as well as set an agenda for a meeting.

Q: What takes place in the meeting with the company?

John Kriz: There are usually two meetings. One would be a conference room meeting with the senior management of the firm where we would talk about their vision for the firm, various business lines they're in, various aspects of the company such as property development, property acquisition, sales, management, and so on. We would also visit a select portfolio of the company's properties so we could match what we see on the ground to what we hear in the strategy discussions with management. During the course of these conversations, it would likely become apparent that some additional information might be helpful. We would share those requests with the company. In addition, it may occur to them there are certain issues they want to be sure they discuss with us.

It's very much a give-and-take type of environment where the company is highlighting issues it believes are important to telling its story, and we pose questions and issues that we think are helpful to reach an understanding of the business. We would also discuss with the company the main issues we look at to determine the most appropriate rating. We also solicit their feedback on the rating.

Q: How does Moody's decide on a particular rating?

John Kriz: Subsequent to these meetings, property tours and document reviews, we arrange a rating committee. In doing so, we share with the company the rating range we seem to be coming out at, and some of the major analytical points that are leading us to this conclusion. This is also done to make sure that nothing's being missed and to ensure that any analytical issues have been fully discussed. We also want to ensure that the firm is aware of what kind of rating we're heading toward. The reason for that is to make sure that everyone's views are on the table and have been appropriately discussed.

The lead analyst, supported by a backup analyst or analysts as the circumstances may dictate, would then make a recommendation to our rating committee, and we sit and discuss it. We endeavor to reach a consensus on the conclusion, and at that point we would communicate to the company what our conclusion is and how we got there.

Q: What are some positive financial traits that could contribute to a positive rating?

John Kriz: Positives include a consistent operating performance, stable profits and strong revenue growth. We would also look for the quality of management; we would look for the risk temperament and appetite of management. On a balance sheet perspective, we look at the overall amount of leverage, as well as the amount of leverage or debt that may be secured. A long, well-laddered maturity structure is far better than a short, not very well-laddered security structure.

Lesia Bates: There are also some broader business issues, such as looking at the industry cyclically with the lodging business. Looking at lodging real estate companies, we note that asset type is very dependent upon macro-economic conditions, and how it impacts both business travel and tourism. Some of the credit factors would be balanced with those industry fundamentals, as well as looking at local market conditions, real estate trends, and supply and demand balance. So, we look at the industry they operate in, the risk associated with that particular industry, and then drill down to the company's specific approach to establishing a strong franchise. In maintaining that franchise through good times and bad times, we look for them to continue generating a strong cash flow to support all of their fixed obligations.

John Kriz: Most of all, we look at these companies as businesses, not agglomerations of assets. We're looking for business discipline and a corporate vision that makes sense. One of the things that many companies find a bit surprising is that they find the rating process extremely helpful for them as managers. Managers find they learn more about their business, and more about the financial risks of their business from the rating process with Moody's. I think they come away with very strong feelings that the effort was really quite worthwhile, and worthwhile in ways they didn't really expect.

Q: Are there some red flags that pop out in a business that isn't healthy?

Lesia Bates: Volatility of earnings is something that would pop out for us. If we see a lot of volatility in the use of debt, that will stand out. If the company's business model shifts continuously, that raises a red flag for us. For example, if this year you're focused on 10 markets and a year ago you were focused on becoming a national player, we would want to know the rationale behind that to understand those kinds of things. We're looking for consistency not only in performance, but also management quality. A big part of management quality is us having confidence in management's ability to execute this plan, so that whether we're talking about a company today or a year from now, the story may have changed somewhat, but the underlining business model has remained consistent.

Q: How does the committee reach consensus on a rating?

John Kriz: We endeavor to reach consensus. In some cases, some analysts may not be on board, and that's okay. But one of the reasons we strive for a consensus is that if some member of the rating committee feels quite strongly about something, we would want to delve in and see if there's something there that other members of the committee may have missed. We certainly want to make sure that we have touched on everything. We would want to ensure that a majority of the rating committee is on board with the rating. While we strive for unanimity, it's not a requirement to reach a conclusion.

Q: How is the rating released?

John Kriz: When we release a rating, it's done through a press release to the public because we want to ensure that the general public receives our opinions at the same time so that no particular group is favored. The press release is a couple pages outlining what the rating is, the main reasons we got there, as well as the main issues we see as having an affect on the rating. For example, it might outline the factors that could cause the rating to be upgraded over time or downgraded over time, as the case might be.

The firm would receive a call from us well before the press release is released to be notified of the initial rating. We would share with the firm the conclusion we came to as well as the analytical issues that compelled us to reach that conclusion. Our typical practice is to share a copy of our press release with the firm ahead of time.

to ensure that the facts are correct.

Q: What are some of the impacts of a rating?

John Kriz: I would use the term high, medium or low rating as opposed to good or bad. Ratings affect the character of one's access to the financial markets, and that has affects on the types of financing choices available to firms. So it's an issue that's treated with great seriousness by companies, as we it's treated with great seriousness by us.

Q: Can a company appeal a rating?

John Kriz: On an initial rating, if the rated firm takes a different view of what rating is appropriate, and they have some information they believe would be germane to the rating conclusion that they'd like to share with so we can reconsider our opinion, we would be pleased to do so.

Q: How does Moody's ensure that ratings have the same meaning across the globe? For instance that an Aaa rating has the same value in the United States as it does in Japan?

John Kriz: This is one of our greatest challenges, because we want a globally consistent rating system. We rate property firms in many countries around the world. We interact with colleagues in different sectors of the rating business, and we have rating committees composed of eclectic people with diverse backgrounds. We do this through the diversity of our people, the diversity of their credit experience and the diversity of our rating committee.

Lesia Bates: I think it's important to note that the rating factors that we look at are the same across the board. The relevant weighting or importance of those factors may change given the local environment. For example, the way business is done in Japan is very different from the way business is done in the United States, so the cultural implications and how they may impact our thinking may be somewhat different. But our colleagues in Japan look at property firms and the issues that affect property firms the same that way we look at them in the United States

Question: Is there anything else you wanted to mention about the rating process?

Lesia Bates: We believe our rating approach is a recipe approach that involves both quantitative and qualitative analysis. We are not formulaic in our approach. Because of this recipe approach, we think our ratings are accurate. Sometimes we get calls from folks who think their company's leverage profile is fine, compared to say another REIT, and they don't understand why their company's rating is different. The difference is usually in the qualitative factors, because there are a number of things that go into a rating. It's not a black and white process.

John Kriz: The point I would emphasize is that ratings are under constant monitoring, and it's not a situation where we would assign a rating and then put it on a shelf. We keep up with companies in the industry on a real-time, all-the-time basis; and the rating process is both qualitative and quantitative. We take a corporate approach to the ratings and look at property companies as businesses. The rating process is very much an interactive one with the issuer, his advisors and others. We approach each company and each rating with an open mind and a fresh perspective. We welcome the input of companies in helping us to understand their businesses as best we can.

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