Friday, April 17, 2009


Real Estate Investment Trusts (REITS) have long been a favorite holding for high-dividend investors. The recent bankruptcy filing of General Growth Properties (GGP) puts the spotlight on this group, particularly the Commercial REITS.

Those following my series, The High Dividend Investor’s Collapsing Dollar Survival Guide, or my newsletter, will note I’ve NO U.S. commercial REITS on my list of recommendations. In the past, they’re holding of hard assets and often generous and stable dividends would have made them legitimate candidates. No longer.

My readers may note that I do have a few Canadian REITS in the portfolio. These include commercial REIT RIOCAN (OTC: CDPYF, TSX: CAR.UN), as well as

· Canadian Apartment REIT (OTC: CDPYF, TSX: CAR.UN)

· CML Healthcare Inc. Fund (OTC: CMHIF, TSX: CLC.UN)

· Northern Property REIT:(OTC: NPRUF, TSX: NPR.UN)

Why? The healthier Canadian banking system makes the lending situation there better, and this is key. Of course, the firms themselves have posted solid results have performed well, and sport high, reliable yields. So far, so good.

What killed GGP was its inability to refinance debt coming due. Much of its operations were ok and it continued to meet current debt payments on most of its malls. For example, in Q4 of 2008, GGP posted a solid 92.5% occupancy, though cash flow suffered along with the rest of the consumer sector.

There’s plenty of potential for more trouble with the commercial REITs. Per Deutche Bank, two thirds of about $154 billion of securitized commercial mortgages coming due between now and 2012 will not qualify for refinancing due to the 35% - 45% decline in property values since their 2007 peak. This estimate could get far uglier if even about 10% of mall properties need to be sold off. There are relatively few buyers for such big ticket properties. Thus commercial property values would drop further, thus lowering the value of the surviving commercial REITs and making financing harder still.

I won’t even get into what declining commercial property values will do to the asset values of the already battered banks that hold the mortgages, though suspension of mark-to-market accounting will help preserve appearances, at least for a while(?). So far the government has been very willing to join the banks in erecting a façade of health, so why not here too. What options do they have?

1. What Income Investors Need To Consider

First, not all REITs are created equal. The commercial sector is the most vulnerable, and the retail sector the most vulnerable of the commercial sector, though there are pockets of relative stability. Residential REITs, healthcare REITS, or even commercial office building REITs with heavy exposure to government or other very commercial stable tenants AND that have manageable debt loads will survive and ultimately prosper.

However, unless you’ve specific well researched evidence or advice suggesting otherwise, be very wary of commercial REITs, especially those with retail exposure. During the next 6-12 months, there are likely to be lots of distressed sales and the sector will be badly depressed, and that might be a time to find opportunities in which the reward justifies the risk. When that time comes, apply the following criteria when evaluating REITs.

2. Criteria for Evaluating REITs

In short, investors need to first consider if the companies have the means to manage their debt load without seeking out new financing sources. If they can do that for the next number of years to survive until things improve, then you can look at how well funds from operations exceeds current debt payments, then consider the safety of the dividend. Like any

A. Specific Criteria Include:

· Relative Debt Load: Again, inability to refinance is what killed GGP. Like any business comprised of big capital assets, be they power plants, pipelines, or retail malls, these firms use lots of debt. Commercial property values are likely to weaken more, making refinancing even tougher. The overriding concern is to look at various measures of the firm’s ability to meet debt obligations without seeking out new financing.

Specifically, examine:

o Debt to equity ratios: These should be much better than 1:1, because in the event of bankruptcy, costs of the bankruptcy process could consume any surplus left after creditors

o Ability to meet long term obligations coming due in the next 5 years, during which time refinancing from conventional sources at affordable rates will be hard. Specifically, what provisions have they made to pay off this debt? Have funds been set aside? When do they have any large debt coming due? How much of unused credit lines, if any, are available.

o Ability to meet short term obligations: For example, calculate the quick ratio (liquid assets/short term obligations) to see how they can manage for the next fiscal year. You want to see something much better than 1:1. In addition to this ratio, look at the actual amounts of liquid assets compared to debt payments and other obligations over the next year.

· Income from Operations: Once you believe the REIT can survive ongoing debt and operating expenses, then look at the day to day health of the business. If the operations aren’t profitable, debt will ultimately be a problem, even if they have the cash for now.

· Get some measure of dividend payout ratio: Once you’re satisfied they’ll survive, how safe is your dividend? Income is usually the reason for investing in REITs in the first place. In general terms, payout ratio is the actual total dividend payments divided by the total distributable cash available after covering current operations and debt payments. For very steady revenue businesses like power suppliers, we like to see payout ratios under 90%. For businesses with volatile revenues like energy producers, we want no more than 70%. For truly troubled sectors like retail REITS, the lower the better, like 60% and lower, to provide a cushion of cash for maintaining the dividend until things improve.

B. Where To Find This Data?

For those not inclined to analyze financial statements, check the Management Discussion and Analysis (aka: MD &A) included with most quarterly financial statements, which you can access on the company’s website. If still unsure, email your questions to investor relations via the email address on that website.


As long as people need places to live, work, and shop, the REITs will have demand. However their need for debt combined with a severe recession and concomitant decline in consumer spending makes investing commercial REITs treacherous at this time, so use the above and other criteria to carefully evaluate investments in REITs, especially commercial REITs, and especially retail REITs.

DISCLOSURE: The author may have positions long or short the above mentioned stocks.


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