Effects of REIT JVs on credit ratings

Many REITs are responding to tight capital markets by raising cash for acquisitions and development through joint ventures (JVs) with institutional real estate investors. Moody's Investors Service expects greater use of JVs between REITs and real estate developers and investors, and cautions that JVs can have significant and complex effects on REITs that investors need to understand.

Joint ventures are simply forms of real estate partnerships. Two broad classes of joint ventures have emerged: Partnerships formed for long-term investment and partnerships formed to facilitate development.

In the first type, the REIT partners with an investing entity, such as an insurance company, that seeks to acquire a strategic long-term interest in a commercial property. The partner contributes capital and the REIT brings capital and its expertise in property management.

The second type - joint ventures formed to facilitate development - involves a REIT partnering with a real estate developer. The partner constructs the building and the REIT takes responsibility for buying the developer's interest when construction is complete.

JVs can provide substantial income benefits for the REIT. A REIT deploying its capital through JVs will own partial interests in many properties, rather than sole ownership of fewer properties. Because REITs typically contract to manage the subject properties (for a fee), this dispersion of capital investments allows them access to income streams that are favorably leveraged relative to their cash contributions.

JVs also provide relationship benefits. REITs can benefit from JVs through sharing the partner's expertise and business relationships. A construction partner, for example, might have local expertise with subcontractors, materials sources and government bodies.

Although the benefits of joint ventures can be significant, REITs' use of JVs to finance acquisitions and development may carry credit risks.

The most significant risk is the incurrence of high levels of off-balance-sheet debt. The reporting of JV finances as required by GAAP falls short of providing investors a full picture, instead masking the underlying leverage of the JV properties. In practice, JVs are usually more highly leveraged than the REIT itself, and are leveraged with mortgage debt to boot.

Moody's negatively views REITs that use JVs as vehicles to bury debt and boost effective leverage, particularly where such practices cause REITs to incur debt outside of their targeted ranges. A complete credit picture for a REIT can only be obtained by looking through the JVs to determine the REIT's true debt exposures and equity interests in its JV properties. Whether or not the REIT retains adequate control over the management of the properties to ensure that its long-term interests are protected is an important issue in this regard. Development JVs, and those investment JVs with fewer characteristics of long-term commitment from investors, do not receive much benefit from the partner's equity contribution, and instead are best analyzed by fully consolidating JVs into the REIT.

Another credit concern is the REIT's ceding of control over the property. Although JV arrangements typically provide for the REIT to retain control over the property's day-to-day operations, as a practical matter the REIT does have to answer to the JV partner, which limits the REIT's flexibility.

Exit strategy is another concern. Where the REIT is contractually obligated or strategically motivated to eventually purchase the properties in the JV, the REIT is most appropriately treated as having retained 100% of the property's downside risk. When this sort of arrangement exists in development joint ventures, the REIT is also left exposed to lease-up risks.

A related credit issue is the degree to which the REIT effectively limits its exposure on a JV's mortgages by specifying them to be non-recourse. The benefit is not absolute because real pressures exist to induce a REIT to satisfy non-recourse mortgages. REITs are dependent on access to the capital markets, and walking away from even a non-recourse JV-related debt could send a bad signal, especially if the property has become a strategic holding for the REIT.

The potential benefits and burdens of joint ventures require intense scrutiny, with each REIT's arrangements presenting a unique set of factors to be evaluated. Moody's believes that most rated REITs have structured their JVs to give REIT debtholders significant benefit. JV equity has a positive credit impact on REITs, which in many cases ameliorates the JV's other, more negative, effects.

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