“Ben Graham's principle of always returning to the financial statements will keep an investor from making huge mistakes. And without huge mistakes, the power of compounding can take over.”

—Michael Price

We're not quite done discussing blue‐chip REITs yet, which is why we need to address balance sheets. As I've already brought up a time or two, private equity real estate buyers like to use debt to partially finance their acquisitions. There are good reasons for this, especially for small‐scale operators. Since debt is a way to circumvent equity capital constraints, it allows owners to stretch their equity over multiple properties, therefore lessening the risk of any single one. Plus, interest payment deductibility creates a tax shield.

For private real estate investors, outside debt also tends to be cheaper than outside equity. That's because the stability and predictability of those cash flows, along with its low price volatility, make real estate a desirable collateral asset against which lenders are comfortable extending credit. Finally, so long as the property's return exceeds the debt's interest rate, adding more debt can actually increase the equity investor's rate of return. This is known as positive leverage.

It would be tempting to conclude then that using large amounts of debt could be equally beneficial for REITs. However, unlike private real estate investors, they can access reasonably priced equity in well‐functioning capital markets. Plus, they're exempt from corporate taxation, which automatically eliminates the tax‐shield benefit of using debt financing. Likewise, their inability to retain large amounts of inside cash due to dividend payout requirements reduces the incentive to issue shares only when equity is overvalued.

Put together, relying too heavily on debt is much less a reward and much more a risk to REITs.

In well‐functioning capital markets, there's an exact offset between higher returns and higher risk. Yes, debt is cheaper than equity. It has priority over cash flows, with equity being the residual claim. But adding it doesn't add value to a REIT because higher leverage implies a higher cost of equity capital. What matters is the overall weighted average cost of capital, which accounts for debt (D), equity (E), and the respective costs of each kind of capital (r_D and r_E). These ideas can be summarized in the equation below and in Figure 12.1:

In addition to greater systematic risk exposure, there are several real‐side risks associated with over‐leveraging.1. Again, REIT investors became acutely aware of these in the Great Recession. During that period, over‐leveraged entities were forced to sell properties whose values had dropped below the outstanding loan balance, often at deep fire‐sale discounts. They then had to recapitalize and raise equity under very difficult market conditions.

Unfortunately, periods of rising versus falling property values can only be fully identified in hindsight. And studies suggest that real estate fund managers are no better at timing their leverage decisions than anybody else in the stock market.1. Further studies still show that, one way or the other, highly levered REITs have substantially underperformed their less indebted peers over time. This is why I stand with Green Street’s Mike Kirby, as quoted in a January 6, 2010, Wall Street Journal story: “At its core, commercial real estate should be an income‐oriented investment … when you over‐lever, you take away those merits.”

More than a decade old or not, you can still take those words to the bank. Prudent financing strategy includes a firm commitment to maintain low leverage, mitigate refinancing risk by matching debt and asset maturity, reliance on unsecured debt as a general rule, and managing interest rate risk using fixed‐rate debt.2.

So what does a strong REIT balance sheet look like? To answer this, investors should first look at two important ratios. For one, there should only be a modest amount of debt relative to its total market cap, the total market value of its assets, or its earnings before EBITDA. For another, there should be strong coverage of the interest payments on that debt and other fixed charges from operating cash flows.

Debt Ratios

Suppose a REIT has 100 million shares of common stock outstanding and its market price is $10 per share, for a total equity capitalization of $1 billion. It also has $100 million of preferred stock outstanding and total debt of $600 million. The debt/market cap ratio can be determined by dividing its debt ($600 million) by the sum of its common equity cap ($1 billion), the preferred stock ($100 million), and the debt ($600 million). The answer is therefore 35.3%.

Admittedly, a minority of analysts, including Green Street, prefers using a ratio based on estimated asset value instead of share valuation. So if a REIT has $100 million in debt and $300 million in total asset values (an estimation of the fair market values of its properties), its debt/asset value ratio would be $100 million divided by $300 million, or 33%. Here's that formula written out:

This method has two advantages, starting with how it's more conservative, since REITs have generally traded at market valuations modestly in excess of their NAVs. It also avoids rapid fluctuation in debt ratios, since their share prices are usually more volatile than their assets' value. Those who use it argue that leverage ratio shouldn't be subject to temporary stock price ups and downs when the price movement has nothing to do with operations or property values. At the same time, it uses estimated asset values, which is subjective – hence the reason why it's not as popular in the end.

Using total debt to asset market value, we can see that the strongest REITs show an average leverage ratio of 35%, whereas the weakest are much higher at 59%.

But here's another factor to consider before you begin scooping up every asset at 35% or better. Both that ratio and debt‐to‐market cap can potentially provide overly rosy pictures when REIT stocks or property prices are at lofty levels. This showed in 2008 and 2009, when both fell dramatically, causing debt/market cap and debt/asset value ratios to spike. That's why we also want to look at debt to expected EBITDA over the preceding or following 12 months.

This enables investors to look at a REIT's indebtedness in the context of its free cash flow before interest payments. That will quite often be more stable than its stock price or even its aggregate property value. In which case, a debt/EBITDA ratio of 5×–7× can be considered acceptable … 4× or less is quite conservative … and above 8× should make conservative REIT investors uncomfortable.

Interest Coverage Ratios

Another way to analyze debt levels is to look at how much their EBITDA exceeds interest payments on their indebtedness, a calculation known as interest coverage ratio. For example, if “Trophy Office REIT” has annual EBITDA of $14 million and carries $100 million in debt that costs $7 million in annual interest expenses, then its interest coverage ratio would be $14 million divided by $7 million, or 2×. An interest coverage ratio significantly below that will often be cause for some concern.

Sometimes analysts also factor in other recurring financial commitments such as dividend payment obligations on outstanding preferred stock or scheduled debt repayments (fixed charges). That ratio is referred to as the fixed‐charge coverage ratio and is a more conservative test. Still others look for interest or fixed‐charge coverage ratios to assess a REIT's ability to service its debt obligations out of current EBITDA.

The following table presents REIT property‐type sector averages of common debt ratios investors may want to consider. Based on data from Nareit at the end of Q4‐19, it provides a recent reference point for REIT capital structure metrics. Note the conservative debt/market cap ratios in many of the sectors. These are caused by rising property values in the economic expansions at the time and by lessons learned from the Great Recession.

Interest coverage, fixed‐charge coverage, and debt to EBITDA ratios all avoid the difficulty of assessing leverage during periods of rapidly changing stock prices and property values. That's a definite check mark for them. However, they do end up penalizing REITs with temporarily non‐revenue‐producing assets such as land or properties under development. They can also unduly reward REITs that are enjoying unusually high temporary rates of return. That's why it's best to examine all the foregoing formulas when examining a prospective purchase's balance sheet.

Debt Maturity

Another crucial aspect of REITs' financing policy is the terms of their debt contracts. Of course, they hold long‐lasting assets, and their debt should reflect that. (This is known as asset‐liability matching.) But longer‐maturity debt also reduces refinancing risk. By this I mean that, if a lender won't renew a significant loan when it comes due – and if no other source of refinancing can be found – a REIT will have to sell off assets at whatever price possible, raise new equity at very dilutive prices, or even file bankruptcy proceedings.

And yes, there are times that lack of lender responsivity does happen.

Longer‐term debt, on the other hand, can actually be cheaper to obtain at times. That's because the cost of debt is a function of default risk, which is related to the level of leverage and the time to maturity. Longer maturities provide the borrower with more time to grow asset value and repay debt outstanding at maturity. Naturally then, blue‐chip REITs should favor long‐term debt.

Also naturally, investors should keep an eye on maturity dates, probably looking to each prospective buy's average debt maturity. It's also preferable for the majority of that debt to come due at least several years down the road. In short, the best of the best stagger these payments intelligently.

Term to maturity also affects debt duration. If that sounds repetitive, duration much more specifically refers to interest rate sensitivity. As debt maturity increases, so can the sensitivity of its value to the underlying interest rate … which brings us right to our next point.

Variable‐Rate Debt

Variable‐rate debt leads to significantly increased interest costs if interest rates rise. Since a large portion of a REIT's total expenses is comprised of interest expenses, substantially higher interest costs can cause a significant reduction in FFO.

So why take out such a loan to begin with? That would be because there's the chance that interest rates will decline, meaning payment amounts will too. Therefore, going that route is essentially a bet on the future course of interest rates.

Since a large portion of a REIT's total expenses is comprised of interest, substantially higher interest costs could cause a significant reduction in FFO. But interest rate shocks are especially problematic for REITs considering how their rental income almost always depends on much more predictable, gradually rising leases. Taking on fixed‐rate debt is a much more balanced and even positive experience, since it improves FFO stability and therefore dividend stability as well.

Some variable‐rate debt can be appropriate. For instance, REITs might want to establish short‐term lines of credit that can be paid off quickly enough through such things as stock offerings; issuing longer‐term, fixed‐rate debt; or selling assets. And the hotel subsector, specifically, can better claim its benefits since interest rates tend to rise when the economy is strong (and vice‐versa), and hotels generally perform well in strong economies.

Ipso facto, variable‐rate debt can serve as a hedge against weak economies, with lower hotel receipts being partially offset by lower interest expenses. The key is the amount of it compared to, say, estimated gross asset value or market cap.

Secured Debt

As previously established, REITs tend to have significant debt capacity considering how their holdings are highly suitable as collateral. Real estate is a tangible, physical asset that's easily verifiable in court. Plus, the commercial kind's cash flows aren't terribly specific to the owner, and there's usually an active secondary market as well. This increases lenders' ability to recover their money if things go badly.

With that said, obtaining unsecured, corporate‐level debt isn't always easy – which works to our benefit.

Only high‐quality REITs with strong balance sheets can source significant amounts of unsecured debt. Lower‐quality entities have to pledge more collateral (which they only have so much of) to finance investments. Blue‐chips, however, just need their names. Lenders know they're good for it.

For these reasons, there's generally an inverse relationship between REIT quality and secured debt, and a positive relationship between firm quality and line of credit capacity.

Conservative and Consistent Dividends

A safe and growing dividend is mandatory to acquire a blue‐chip label. That much should be obvious, but let's discuss it for a few paragraphs anyway, starting with AFFO.

Maintaining a modest payout ratio is good policy for two reasons: taking advantage of opportunities that come up and insuring against pitfalls. While REITs legally can't keep too much of their money, they should be saving up some amount to properly handle life's twists and turns, both positive and negative. If they're paying out too much in dividends, that means they're not in good shape to handle whatever's around the next corner.

When looking for an attractive figure here, it's best to consider free cash flow in terms of AFFO, not FFO. That's because we want to properly calculate for recurring capital expenditures, which can take quite a bite out of available money for dividend distribution – and therefore out of properly understanding what a REIT has going for it. If AFFO is $0.95 and the dividend rate is $0.85, the payout ratio would be 89.5% ($0.85 ÷ $0.95). Or we can reverse the formula to get a dividend coverage ratio of 112%.

It's important to know that payout ratios do fluctuate over time, increasing during periods when cash flow is weak. They can also go up because a company decides it doesn't make sense to be buying anything up in a given season. In that case, a higher payout ratio might actually be the most efficient use of a REIT's cash in the moment. Growth should never be forced.

Higher payout ratios therefore don't necessarily mean dividend cuts are looming. Most REITs in most environments are good at avoiding that. All the same, excessively high figures aren't something to mess around with for the simple reason that dividend cuts aren't something to mess around with. It doesn't say anything positive about a company if it can't manage its money well. That's why most blue‐chips have lower dividend payout ratios.

They want to be properly prepared for whatever is coming down the road.

Corporate Governance

It might seem easy enough to shrug off REITs' board of directors. But they do matter, especially when keeping management honest, providing insider connections, and acting as a worthwhile advocate for shareholders.

Some questions to ask about a REIT's board include: Are the vast majority of directors truly independent, and willing and able to reject policies unfriendly to shareholders? And have these independent directors invested personal funds in the REIT so that they have skin in the game? If so, how much? How have they resolved issues before?

Basically, we want to see them come together with management to create structures that protect and promote shareholder positions. While this might be the least of an investor's concerns, we should still keep an eye on who's who and doing what in this regard.

It goes without saying that blue‐chip REITs tend to have good, if not great, corporate governance. The more efficient the oversight, the more smoothly the business beneath it can run.