REIT Structure Reinforces Conservative Financial Policies

By Reinor Bazarewski, Associate Director, Fitch Ratings: Corporate entities issued record-breaking amounts of special dividends in December 2012 with the fiscal cliff on the horizon, a practice that equity REITs have largely avoided.

Corporate entities issued record-breaking amounts of special dividends in December 2012 with the fiscal cliff on the horizon, a practice that equity REITs have largely avoided. Fitch Ratings believes exercising such fiscal prudence will benefit equity REIT bondholders in the long run. 

REITs are required to distribute at least 90 percent of taxable income as dividends. As a result, this inhibits REITs from accumulating large cash balances through internally generated free cash flow to pay special dividends or conduct share repurchases. Additionally, bank covenants may restrain a REIT’s ability to make certain restricted payments. Notable exceptions since 2006 include Equity Residential increasing leverage to repurchase $1.2 billion of common shares in 2007, and AIMCO repurchasing nearly $800 million of shares between 2007 and 2008. Nonetheless, given these structural restrictions, Fitch does not expect sizable share repurchases or special dividends over the near-term. Fitch views this as favorable from a fundamental credit perspective. 

Most entities will continue to grow their portfolios on a leverage-neutral basis and issue sizable amounts of equity to finance acquisitions and development. This was evidenced by Equity Residential’s $1.2 billion common equity issuance/continued asset sales to finance a substantial portion of its Archstone acquisition. Another example was Digital Realty’s GBP716 million acquisition of the Sentrum portfolio, which was financed primarily with an $830 million common equity offering.

The REIT structure also implicitly enhances management discipline with respect to capital allocation. Since REITs are unable to retain sizable amounts of cash flow, they are much more dependent on accessing the capital markets than standard corporate borrowers. As such, REITs essentially require tacit approval from investors to invest new capital in acquisitions and other growth opportunities, whereas standard corporate entities lack this implied market check.

Fitch expects REITs to continue maintaining prudent financial policies and mostly conservative views on leverage over the near-term.