By Michael Aneiro
Barclays is out with an extensive report on the pros and cons of REIT conversions, at a time when it counts at least 15 firms actively considering a partial or total conversion to a real estate investment trust structure, listing CBS (CBS) unit CBS Outdoor, Lamar Advertising (LAMR), Clear Channel Outdoor (CCO) and Waste Management (WM) among them. Barclays counts at least 30 other corporate bond issuers with real estate worth at least half of their enterprise values that could explore REITs structures to unlock value.
Barclays says REIT conversions often take months or years, much longer than other corporate restructurings or transactions, citing the two most notable recent conversions: American Tower (AMT), which was working actively toward a REIT conversion as early as 2007 but only completed the process in late 2011; and Weyerhaeuser (WY), which publicly discussed a potential conversion as early as 2008 but finished in 2011. From Barclays:
Generally, the desire to convert to a REIT stems from a combination of efficiently balancing tax liabilities; boosting public valuations, given that REIT multiples are near all-time highs due to investor interest in current yield; and monetizing real estate holdings. For credit, REIT conversions have very situation-specific implications. The negatives are clear: becoming a REIT limits retention of capital, creates higher ongoing payout obligations, and increases the reliance on capital markets. However, these are moderated or offset by more conservative views on leverage/capital allocation and potentially enhanced covenants.
To qualify, REITs must distribute at least 90% of taxable income in the form of dividends; at least 75% of gross income must come from qualified investments; at least 75% of total assets must be invested in real estate; the taxable REIT subsidiary can be no larger than 25% of the REIT’s assets; and there must be a minimum of 100 shareholders and no more than 50% of shares held by five or fewer individuals.
Barclays sees three key factors in analyzing REIT conversions: the stage in the conversion process; whether the conversion will be full or partial; and whether there are covenant restrictions that create differential performance within the capital structure. Based on those factors, Barclays views CBS’s plan to convert CBS Outdoor to a REIT and spin it off to shareholders as “a modest credit negative.” saying it expects the tax-free spin-off to result in less than 10% of consolidated EBITDA exiting the company.
On balance, Barclays says REIT conversions have negative credit implications for issuers:
First, since REITS distribute 90% of their taxable income, they are unable to retain significant free cash flow. Specifically, after adjusting for depreciation (included in taxable earnings), we estimate that REITs retain 30-40% of cash flow, on average. Correspondingly, they are much more reliant on capital market access (equity and debt) to fund reinvestment in the business or external growth than standard corporate issuers. This is particularly true for non-traditional REITs, which are real-estate “lite” (e.g., outdoor advertising) and, hence, do not have access to the property mortgage market, which can be a vital source of capital in distressed times.
Finally, REITs have a significant ongoing dividend commitment, which can strain liquidity. In periods of weaker operating performance, they can be left with the unpleasant choice of cutting their dividends or raising new capital to meet obligations. This was exemplified in 2009, when more than 60 REITs tapped the equity markets at dilutive levels to address insolvency concerns.
On the positive side, Barclays says REITs structure enforces prudent capital allocation and leverage, with REIT issuers rarely repurchasing shares or issuing special dividends. Similarly, upon conversion, REITs will often reduce leverage to target investment grade ratings. Barclays cites Crown Castle (CCI) indicating it plans to reduce leverage and achieve investment grade ratings by January 2016, when it expects to complete its REIT conversion. In addition, high-grade unsecured REIT debt issuers offer unique covenant protection to investors, typically limitations on debt incurrence, minimum coverage and maintenance of adequate unencumbered asset coverage.