Fitch: Privatized U.S. REITs Will Not Mean Unpaid Bondholders.

NEW YORK -- While recent merger announcements involving U.S. real estate investment trusts (REITs) have left uneasy bondholders wondering if their rights are protected, Fitch Ratings says that certain features inherent in REIT bonds should protect investors from merger risks.

REITs were involved in 16 merger transactions worth more than $26 billion last year according to the National Association of Real Estate Investment Trusts, a trend that has continued this year with more than $3.2 billion of investment grade-rated bonds affected by merger activity. Recently announced and closed transactions like the acquisition of CarrAmerica Realty Corporation and Arden Realty, Inc. by affiliates of Blackstone Group and GE Commercial Finance respectively, and the purchase of Centerpoint Properties by an affiliate of CALPERS offer high profile examples of the privatization of REITs with high grade bonds outstanding.

The range of possible implications for bondholders are broad and include prepayment, downgrades, and restructuring. The outcomes, which are related to each acquirer's specific investment objectives, are difficult to handicap. However, according to Managing Director Tara Innes, 'REIT bonds enjoy some key structural attributes which offer bondholders better prospects for prepayment than those available elsewhere in the investment grade bond arena, which likely means that most REIT bondholders will be offered prepayment at yield maintenance when REITs are privatized.'

In acquiring public REITs, the majority of buyers plan to increase leverage to improve equity returns. Under that scenario, few leveraged buyers will want to live with either the leverage constraints contained in REIT bonds or, the onerous reporting standards necessary to comply with SEC requirements.

REIT bond indentures contain language that prevents REIT Operating Partnerships (the bond issuing subsidiaries of most investment grade rated REITs) from being swallowed up by acquirers unless all of the bond obligations are specifically assumed by the new owner. 'Predominantly, these obligations include financial covenant protections, yield maintenance provisions, and reporting requirements associated with publicly registered securities,' said Innes. 'Together, these provisions have spared many REIT bondholders from the fate of fixed income investors in other corporate sectors.'

At the core of protections for bondholders are the non-call features of REIT bonds. The REIT bond market is generally comprised of medium to long term, fixed-rate obligations. The terms of the bonds, which are designed to insure predictable yields for investors, generally prohibit prepayment, without yield maintenance. Consequently, it is often difficult, and can be extremely expensive, to repay outstanding bonds of an acquired REIT without paying significant premiums to a bond's par amount. However, because they are tied to U.S. Treasury Note yields, prepayment premiums decline as Treasury yields rise, and prepayment premiums could cease to be an impediment to privatization should rates rise further.

Another essential component of REIT bondholder protections is language requiring the issuers of bonds to survive as a legal entity. This provision restricts acquirers from dissolving bond issuers unless all of the bond obligations are specifically assumed by the acquiring entity. These provisions insure that the terms agreed to in the bond indenture continue to be the specific responsibility of the surviving entity.

Alone, these protections have done little to comfort investors holding bonds issued by investment grade-rated companies, which are later acquired in highly leveraged transactions. However, in concert with these provisions, REIT bondholders benefit from financial covenant constraints contained in REIT bond indentures. Similar financial covenants, quite unusual in the high grade bond market, are common to bonds issued by below investment grade-rated companies. A decade ago, when REITs first approached the unsecured debt markets, issuers agreed to incorporate these covenants and to operate their businesses within the parameters of four basic financial covenants, in order to gain access to wider support from bond investors.

The financial covenants incorporated in REIT bond indentures generally include the following requirements; issuers are prohibited from exceeding a Total Debt to Total Assets ratio of 60%, Secured Debt to Total Assets is restricted to 40%, issuers must maintain unencumbered assets with an undepreciated book value 1.5 times (x) outstanding unsecured debt, and they must also maintain earnings that exceed required interest payments by 1.5x. Most REIT bond indentures include all of these covenant protections though departures from the standard package exist. A few indentures incorporate covenants that rely on market value leverage calculations as opposed to the traditional, and more prevalent, book value leverage metrics. Such covenants appear in the bond indentures of Boston Properties, Vornado Realty Trust, Archstone-Smith, Equity Residential, Simon Property Group and Rouse. In at least two cases, bonds have been issued by investment grade-rated REIT issuers without unencumbered asset protections, those of Archstone-Smith and Rouse.

Financial covenants have proven especially effective in protecting bondholders from the potential pitfalls of merger and acquisition activity. Most of the public-to-private merger activity, to date, involved the levered acquisition of public REITs. These companies, pre-acquisition, carried modest amounts of leverage (investment grade) and boasted substantial pools of unencumbered assets. By increasing levels of total debt and obtaining secured financing, levered buyers can meaningfully improve equity returns, though the risk profile of their investment may increase.

Finally, as registered securities, REIT bonds offer investors SEC oversight under the requirements of the Securities and Exchange Act of 1934, which outlines periodic reporting requirements including the mandatory filing of issuer specific financial reports.

Financial covenants provide REIT investors with significant downside protection by limiting the incurrence of additional debt. However, the covenant levels contained in REIT bond indentures generally prevent credit profiles from deteriorating below the BB rating level. So, while the risk of default is significantly higher, the return to bondholders remains the same. Further, some acquiring companies have avoided financial covenant defaults by leaving the original issuer intact (as a subsidiary) at leverage levels close to the covenants but, substantially leveraging up the parent company. Though subsidiary lenders may be structurally senior to parent company lenders, there is a significant likelihood that the effects of consolidation in bankruptcy would eliminate these benefits to REIT bondholders. While Fitch sees some privatized REITs operating with weaker credit profiles at or near the covenant levels, this prospect is less likely particularly given the onerous nature and expense of SEC reporting requirements associated with registered securities.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.