Lower leverage matters, says KBRA, because in a distressed capital market, “the value of a REIT's unencumbered asset pool would ultimately determine both the issuer's range of options in replacing or retiring unsecured debt, and the consequences of having to face lenders eager to extract concessions.” A REIT with lower unsecured leverage could face untimely maturity in a hostile bond market “without irreparable diminution to the size or quality of its unencumbered asset base.” Conversely, with a higher-leveraged REIT in the same situation, “the outcome for unsecured bondholders could be markedly different, particularly for bonds with longer-dated maturities.”

Given the industry's efforts to reduce leverage following the Global Financial Crisis, “many REIT issuers are currently generating sufficient unencumbered property NOI to self-fund unsecured debt maturities,” the report states. “While high payout ratios have historically been cited as a negative ratings factor, the growing number of REITs that are able to self-fund unsecured maturities may come as a surprise to many investors.”

However, CMBS enjoy a number of advantages that enable securitized deals' senior debt to achieve AAA ratings, KBRA points out. Among them are superior property type and market diversification, the structural allocation of losses to subordinate classes and principal payoffs/recoveries to senior classes which provide for deleveraging, amortization of loan principal, protection against rising interest rates over the life of the transaction, servicer advancing and the use of borrower structures that employ special-purpose entities to ring-fence loan collateral.

“As REITs lack these enhancements, it is unlikely that they can achieve the same level of ratings,” the report states. “However, they do benefit from a number of other credit positives including an effective cross-collateralization of assets, and the ability to raise common equity in even the toughest market conditions.”

NEW YORK CITY—Do REITs' credit metrics deserve more, well, credit from ratings agencies when it comes to rating the companies' bonds? A special report from Kroll Bond Rating Agency says this may be the case, while acknowledging advantages enjoyed by the senior debt in CMBS transactions that lead to AAA ratings.

KBRA finds that REIT bond leverage, defined as unsecured debt/unencumbered asset value, is “well below levels suggested by other generally accepted REIT credit metrics, and a fraction of the look-through leverage commonly found in AAA-rated CMBS conduit and Freddie Mac K-Series securities.” Looking at unsecured loan-to-value ratios, for instance, the median for REITs is 33%. That compares to a mean of 46% for the most subordinate AAA class in conduit CMBS deals issued in 2016 and 2017.

The gap is even wider when looking at apartment REITs. For the eight companies reporting unencumbered asset book value, the median unsecured LTV is 22%, compared to the 56% mean look-through LTV for the most subordinate AAA class of Freddie Mac K series deals issued over the past two years.

Not that this is always readily apparent. “Unlike CMBS where recent appraised values are a reference point for both loan and bond-level leverage, measurement of REIT unsecured leverage remains elusive,” according to KBRA. “US REITs are neither required nor inclined to report marked-to-market asset values, which can either be inferred from REITs' total market capitalization or estimated via roll-up of underlying asset values based on private market capitalization rates.”

Lower leverage matters, says KBRA, because in a distressed capital market, “the value of a REIT's unencumbered asset pool would ultimately determine both the issuer's range of options in replacing or retiring unsecured debt, and the consequences of having to face lenders eager to extract concessions.” A REIT with lower unsecured leverage could face untimely maturity in a hostile bond market “without irreparable diminution to the size or quality of its unencumbered asset base.” Conversely, with a higher-leveraged REIT in the same situation, “the outcome for unsecured bondholders could be markedly different, particularly for bonds with longer-dated maturities.”

Given the industry's efforts to reduce leverage following the Global Financial Crisis, “many REIT issuers are currently generating sufficient unencumbered property NOI to self-fund unsecured debt maturities,” the report states. “While high payout ratios have historically been cited as a negative ratings factor, the growing number of REITs that are able to self-fund unsecured maturities may come as a surprise to many investors.”

However, CMBS enjoy a number of advantages that enable securitized deals' senior debt to achieve AAA ratings, KBRA points out. Among them are superior property type and market diversification, the structural allocation of losses to subordinate classes and principal payoffs/recoveries to senior classes which provide for deleveraging, amortization of loan principal, protection against rising interest rates over the life of the transaction, servicer advancing and the use of borrower structures that employ special-purpose entities to ring-fence loan collateral.

“As REITs lack these enhancements, it is unlikely that they can achieve the same level of ratings,” the report states. “However, they do benefit from a number of other credit positives including an effective cross-collateralization of assets, and the ability to raise common equity in even the toughest market conditions.”