Bank Borrowing Risks Remain for REITs

By Steven Marks

Steven Marks, Fitch Ratings

Bank borrowing by U.S. REITs surged post-crisis, despite strong unsecured bond market conditions. Bank borrowing grew in tandem with the economy exiting the recession as a surrogate for longer-term, and more expensive, unsecured bond issuance. Five-year to seven-year unsecured term loans became more attractive than unsecured bond issuance, due to more flexible tenors, lower all-in cost and prepayments without penalty.

However, both the public and private placement bond markets will likely not be as robust through the next phase of the capital markets cycle as in recent years. Issuers may have less liquidity or “dry powder” available via their commercial banking relationships should they need to access unsecured debt funding during a period of tightening. This level of bank borrowing exposure can constrain corporate credit quality for some issuers, in some cases causing downgrades and negative outlook changes.

A Look Back

Despite an improved market environment over the last decade, bank borrowing—while somewhat moderated—continues as a primary source of capital funding for REITs. Risks remain that could pose problematic for the industry if the bond markets see a tightening in capital access as the current cycle matures and bank borrowing exposure currently sits at only 2.8 percent less than 10-year highs.

Any meaningful relief from risk is immediately tempered when historic bank borrowing data is reviewed. Today, U.S. REIT bank borrowing remains nearly twice what it was as of year-end 2010—before it became a more meaningful funding source. During a period of modest organic growth via limited development pipelines and a challenging acquisitions environment due to low cap rates and shares trading below NAV, bank funding provides cheaper access to capital and helps grow funds from operations.

Term loans comprise about 67 percent of the sector’s total bank borrowing as of Dec. 31, 2017, while they were only 30 percent of bank borrowing in 2010. In 2016, bank borrowing in the form of term loans peaked at 70.1 percent.

In this environment, REITs could find themselves with less liquidity available at commercial banks when incremental bank funding needs arise. Public and private placement bond markets could potentially begin to dry up, as this capital market cycle begins to wind down, leaving REITs with less access to bank-funded unsecured debt.

What does the future hold for U.S. REITs? Despite the risks associated with access to capital, the outlook for the U.S. REIT sector remains stable. Continued positive property fundamentals across most asset classes, along with consistent leverage and coverage metrics, mark a positive foundation for the industry. Opportunities for access to funding may evolve over time—but it is likely that strong companies will continue to find themselves able to tap capital when needed.