Capital Structure in the REIT Sector - Green Street Advisors

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Capital Structure in the REIT Sector — July 1, 20094III. How Does the Rest of Corporate America Do It?Whereas real estate execs have historically had to choose from an abbreviated menu of financing options(what flavor of secured debt do you prefer?), other large companies have enjoyed a lengthy list of alacarte options. Now that REITs are allowed to order off the adult menu, there is presumably much to belearned by looking to see which items are preferred by the long-time diners.REITs use far more debt than most companies. Tech companies use a lot less. It appears thatthe history of the two sectors has created cultures that arguably no longer make sense.Key Leverage Ratios for S&P 500 ConstituentsNet Liabs % of Tot Mkt Cap60%50%40%30%20%10%0%54%Net Liabilities as a % of Total Mkt CapitalizationNet Liabilities/EBITDA8.321%9%1.60.9REITs S&P 500 (ex financials) Tech Companies10.08.06.04.02.00.0Net Liabilities/EBITDAThe figures shown for REITs and the S&P are the median value. For tech companies it’s the average. The medianvalue for tech companies is zero. Net liabilities equals total liabilities less current assets and excludes preferred equity.50%% of S&P Constituents (ex Financials) that Use MoreLeverage than REITs25%0%18%Net Liabilities % of Tot Mkt Cap2%Net Liabilities/EBITDAThe key takeaway is that, excepting companies engaged in the business of finance (e.g. banks and insurancecompanies), most corporations maintain a conservative posture with regard to leverage. The medianleverage ratio (net liabilities/total market capitalization) for non-financial members of the S&P 500is 21%, a figure that is well below the 54% median for the REITs in that index. Similarly, the median NetLiabilities/EBITDA multiple of 1.6X for S&P members stands in stark contrast to the 8.3X figure forREITs. Only 2% of S&P members have higher Net Liabilities/EBITDA multiples than the typical REIT!At least as interesting as these averages is the fact that a large number of this country’s premier corporations(e.g. Microsoft, Cisco, Johnson & Johnson, Coke, McDonalds, Exxon Mobil, etc.) choose to operatewith little or no debt at all (Appendix B provides these statistics for each of the 50 largest US corporations).Considering that each of these blue-chips, and virtually every member of the S&P 500, is a taxablecorporation (and not a pass-through vehicle like a REIT), the conservative leverage stance stands instark contrast with the norms of the REIT industry.A common refrain heard from real estate industry participants goes something like, “the stability of realestate cash flows allows higher debt levels for REITs”, which purportedly explains why REITs havehigher debt levels than most companies. However, this point is relevant only when asking, “How muchdebt can I get”? It has nothing to do with answering the far more important question, “How muchshould I have?”WWW.GREENSTREETADVISORS.COM© 2010, Green Street Advisors, Inc. - Use of this report is subject to the Terms of Use listed at the end of the report.This report contains copyrighted subject matter and is covered under the Green Street Advisors' Terms of Use.Green Street Advisors reserves all rights not expressly granted.
Capital Structure in the REIT Sector — July 1, 20095IV. What Would Miller & Modigliani Have to Say?Merton Miller and Franco Modigliani had a profound impact on modern finance theory, and nowherewas their work more pioneering, nor enduring, than the insights they provided on leverage. In a paper(which was instrumental in winning its authors the Nobel Prize in Economics) published in 1958, Mssrs.Miller and Modigliani (M&M) postulated that, in a perfect world, the level of debt at a company shouldhave no impact on the value of the company, i.e. the price of the stock. Put differently, the value of a firmis tied to the value of its assets (both tangible and intangible), and how one chooses to divide this valuebetween debt holders and equity holders has no bearing on overall value. Very simply, as debt increases,risk-averse investors demand a higher return on the equity, and any improvement in net income pershare generated by taking on more debt is fully offset by a decline in the multiple the market will awardthe shares.M&M: The Boost Leverage Provides to FFO is Offset by Lower Multiples$2.50FFO per ShareP/FFO Multiple14.0FFO/Sh$2.00$1.50$1.00$0.50$0.86$0.89$0.95$1.06$1.3312.010.08.06.04.02.0P/FFO Multiple$0.000% 10% 20% 30% 40% 50% 60% 70% 80% 90%Leverage as % of Assets0.0In subsequent revisions to their initial theorem, M&M acknowledged that their “perfect world” assumptionwas not realistic, and that there are two big exceptions that result in the conclusion that an “optimalleverage ratio” exists for most companies. The two exceptions:1. Taxes: Tax laws in most countries allow companies to deduct interest expense but not dividendpayments. This creates an “interest tax shield” that has very real value to any taxable company thathas debt. Taken on its own, this issue would suggest that all taxable corporations should be veryhighly leveraged so as to minimize the entity’s tax bill.2. Costs of Severe Financial Distress: The odds that a firm will incur sizable costs associated with severefinancial distress (e.g. bankruptcy) increase as leverage goes higher. This puts a cap on howmuch leverage any firm should have and serves to offset the value of the interest tax shield athigher leverage ratios.WWW.GREENSTREETADVISORS.COM© 2010, Green Street Advisors, Inc. - Use of this report is subject to the Terms of Use listed at the end of the report.This report contains copyrighted subject matter and is covered under the Green Street Advisors' Terms of Use.Green Street Advisors reserves all rights not expressly granted.
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Capital Structure in the REIT Sector - Green Street Advisors

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