Sunday 18 August 2013

The Hidden Risks of Buy-and-Leasebacks for Industrial REITs

Buy-and-leaseback arrangements are quite common among some of the industrial REITs. They buy a property and lease it back to the original seller for a no. of years. The advantages of this practice are it increases the distribution to shareholders, diversifies the sources of rental income and has the potential for capital gains when the property is eventually sold. However, there are risks involved in this practice.

While the property is a long-term asset often lasting 50 years or more, the lease agreement is a much shorter one that lasts between 3 to 7 years (with extensions at the options of the tenant). The thinking behind buy-and-leaseback arrangements is that the REIT would be able to find a tenant and maintain or increase the rental income for the intended holding period of the property. However, some of the industrial properties are highly customised ones. The pool of potential tenants would likely be limited to those in the same industry as the original tenant (Of course, there is always the option of pulling down the property and redeveloping it). Given the small pool of potential tenants, would there be sufficient competition for the industrial space to maintain or increase the rental income? This has not even considered the fact that Singapore is reducing the intake of foreign labour that many industries depend on and there are less expensive places overseas to do business. If the rental income is reduced, the value of the property will take a hit. Yet, the loan originally taken to finance the acquisition remains unaffected and still needs to be serviced and eventually paid off. There will be lower distribution for shareholders. In addition, with a lower valuation, the debt-to-asset headroom will be reduced, leading to less property acquisition opportunities in future and moving the REIT closer to the Loan-To-Value (LTV) covenants in its debt obligations. Of course, the extent of the impact will depend on the size of that particular property relative to that of the REIT's property portfolio.

Conservatively, the buy-and-leaseback arrangement should be treated as a financing transaction for the seller with the property as the collateral. However, in this respect, REITs are at a distinct disadvantage compared to banks. Let us compare the case of a company taking a loan from the banks using the property as the collateral versus the case of the company engaging in a buy-and-leaseback arrangement with the REITs. Banks will have the following advantages over REITs:
  • Banks can request for other collaterals, whereas the only collateral for REITs is the property.
  • Banks can give a lower loan amount than the value of the collateral, whereas REITs usually pay close to the valuation of the property.
  • Banks can monitor the valuation of the collateral and ask for margin top-ups if the LTV ratio rise above a certain threshold. REITs will have to absorb the reduction in valuation.
  • Banks can demand immediate repayment of the loans and seize the property for sale if the company does not service its loans. REITs can only fall back on the rental security deposits.
  • Bank loans usually contain cross-default covenants, i.e. if the company defaults on one loan, it will trigger automatic defaults on all other loans and banks can demand immediate repayment of all these loans. Lease agreements do not have such covenants and cannot ride on the cross-default covenants of bank loans, i.e.a default on a lease agreement does not trigger a default on the loans.

It is worth noting that if the REIT takes on a loan to finance the buy-and-leaseback transaction, it is actually on the short side of both transactions, i.e. it is subject to the protective features of the loan transaction but the lease transaction do not offer comparable protection.

In conclusion, a buy-and-leaseback arrangement provides opportunities for REITs to increase their rental income and distribution to shareholders. However, there are also risks involved. REITs will need to exercise caution before entering into such transactions.

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