Repeat of ’06-’07 LBO Wave Unlikely for Equity REITs Post-Dell

By Britton Costa, Associate Director, REITs, Fitch Ratings: Dell Inc.’s recently announced leveraged buyout spurred speculation as to what other sectors might see as an increase in LBO activity considering the low interest rate environment.

Dell Inc.’s recently announced leveraged buyout spurred speculation as to what other sectors might see as an increase in leveraged buyout activity considering the low interest rate environment. Equity REITs are logical candidates given their secured debt-conducive real assets. With that being said, Fitch Ratings believes REIT LBOs are unlikely given the still constrained new issue CMBS market and the traditional covenants in unsecured bonds.

Current market conditions are markedly different than those of 2007, when CMBS issuance was at an all-time high and LBOs took CarrAmerica, Equity Office Properties, Innkeepers USA and Archstone-Smith private. Each of these transactions was predicated on the placement of additional secured debt on the portfolio and, in the case of EOP specifically, CMBS debt. It is improbable today’s CMBS market has the willingness or capacity to finance a similar volume to a single borrower due to its absolute and relative size. Today’s market is approximately a quarter the size of 2007’s despite the expectation for continued significant annual growth. The likelihood of REIT LBOs may increase as the depth and breadth of the CMBS market improves.

Further diminishing the likelihood of REIT LBOs are the traditional maintenance covenants in REITs’ unsecured bonds that limit the total amounts of secured debt and total debt to 40 percent and 60 percent of undepreciated assets, respectively. Consequently, acquirers would be forced to either limit the amount of debt incurred or negotiate with bondholders for a consent payment and subsequent tender of the bonds. The former likely diminishes the return profile to a point where a deal may not occur. The latter places bondholders in a pivotal and potentially valuable “blocking” position, and acquirers would need to factor sources of funds to redeem these bonds and pay tender costs into their buyout analyses.

Conversely, corporate securities such as preferred stock are unprotected by consent-inducing covenants. As such, they are at risk for being deeply subordinated to substantial property-level debt at the private company in the unlikely case of an LBO. The increased inclusion of change-of-control and coupon step-up provisions in REIT preferred stock documentation only partially mitigate this risk for investors.