The Ratings Game How much debt is too much? Is real estate condemned to relive its past? For answers to those and other burning questions of the day, we turned to Lisa Sarajian, who oversees the REIT rating effort at Standard & Poor’s. by Barry Vinocur

Despite this year’s REIT meltdown, Sarajian says she’s hard pressed to label what’s happening as a “sky is falling” situation. More to the point, Sarajian stresses that the bulk of the companies she and her colleagues are following and rating not only have pretty solid debt service coverage ratios, but they also are by no means highly levered. Furthermore, she says, the companies have much larger and much more “financeable” portfolios than at any time in the past five to 10 years.

Before joining S&P, Sarajian was a research analyst and due diligence officer for Financial Service Corp. in Atlanta. Previous to that, she was a corporate lending associate with Citizens & Southern National Bank (now NationsBank).

During a recent phone interview, Sarajian provided an overview of the REIT rating process, as well as comments on topics ranging from off-balance-sheet financing and development risk to coverage ratios and industry consolidation.

How many companies do you rate?

We’re currently following about 115 companies. Roughly 75 are equity REITs. The REITs run the gamut from apartments, office, retail, and industrial to self storage, healthcare, net lease, and everything in between.

How many people are in your group?

I am part of a 10-person team. I have three senior analysts, two of whom are team leaders. Typically, our analysts have a lending or an investment banking background. It’s a very deep bench.

Tell us about the methodology underlying your ratings.

It focuses on assessing the company’s overall business position as well as its financial risk profile. The rating approach will generally be the same regardless of property type.

How do you evaluate each of those broad categories?

When we evaluate a real estate company’s business position, we focus on four broad categories: market position; asset quality; diversification and stability of operations; and operating strategy, which includes focusing on the company’s management team.

The company’s standing within the sector, which might encompass market share, track record, and reputation, provides insight into how resilient that company will be during a cyclical downturn, for example. The perceived quality of the company’s holdings or asset quality, combined with the diversification benefits of a multiple asset portfolio, help us determine the volatility or stability of cash flow performance for a portfolio through national or regional economic downturns, as well as local economic downturns. Finally, our assessment of a company’s senior management team and the company’s stated strategic plan sheds light upon the future prospects for: individual asset performance, portfolio growth, and the expected overall direction of the company.

What about the financial risk profile?

We determine that by focusing on a number of key factors, including financial policy, profitability, capital structure, cash flow protection, and financial flexibility. To a great extent, the financial policies set forth—or in some instances not set forth—by management establish the framework for the company’s capital base. So, the degree to which and the manner in which management uses debt, the type of debt, and the amount of capital retained internally are largely responsible for the portfolio’s ability to achieve strong returns and maintain comfortable debt coverage. Financial flexibility is certainly key to any company’s ability to ride both economic, lending and/or equity funding cycles.

What about determining net asset value? A lot of sell-side and buy-side analysts use it as one of several valuation tools?

Because book value for most of these companies is meaningless, we do our own valuation so we can derive a meaningful measure of leverage. One of the things we require, much to the chagrin of some of the issuers we follow, is that they provide us with very detailed property level NOI information for their portfolios. That information is not shared with the public. The way this works is that we send the company what we call a property diskette. They populate the template that we provide with data. We use that data to value the company’s portfolio.

Though some analysts and companies focus on debt-to-total market cap, that doesn’t seem to be a measure that most investors and analysts put much stock in. How do you gauge leverage?

Like most everyone else, we calculate debt-to-total market cap, but it’s not something that we generally buy into either. It’s too dependent on the market’s assessment of a lot of factors to be really useful. We’re much more focused on debt service coverage. Our experience in the late 1980s, following the handful of REITs that we did at the time, was that a measure such as debt-to-total market cap was far less helpful in assessing a company’s credit worthiness than was debt service coverage.

Can you give us a number?

As a general rule of thumb, a two times coverage ratio is what’s tolerable at a low investment grade rating. There are a number of variables, however, that can distort coverage ratios. For example, an interest coverage ratio of two times might look great for a particular issuer. But if a company has a large development pipeline and a lot of capitalized costs, that same debt service coverage ratio might not look as good. Similarly, you might have a company with amortizing debt on its balance sheet, which also has to be taken into account when looking at debt service coverage. Our challenge is to take all of those factors into account and then to provide bondholders with a means to compare companies to one another.

What are some of the other factors that come into play during this part of your analysis?

If, for instance, we were looking at 10 companies and they all had the exact same size development program, we would step back and look at the cost of each company’s debt. Is it above market rate debt, at market rate debt, or below market rate debt? We also look closely at maturities. If company A has a two times debt service coverage but its debt matures in five years, that’s not as good as company B that might have a 1.7 coverage ratio but has a longer term on its debt. In that instance, we would probably be more tolerant of a slightly lower coverage ratio because it’s “safer coverage.”

There’s a lot of talk about companies levering up. To some extent that talk is being driven by the fact that REITs cannot access the equity market because of their stock prices. But there’s more to it than that. Some analysts, CEOs and CFOs, as well as veteran market observers have argued for some time that REITs were underleveraged. What’s your view?

The mantra that higher leverage is what the market is saying it wants is debatable. Is the market penalizing these companies because they are underlevered or because it’s concerned about future growth? Our view is that it’s going-forward growth that’s the issue. If anything, the market is probably advising caution on the leverage issue.

From a credit standpoint, there are many ways companies can raise their leverage in a credit neutral way. For example, on its face, off-balance-sheet financing is generally credit negative. But there are ways to pursue off-balance-sheet joint ventures so that the company gets a bit more leverage without having a negative impact from the point of view of the bondholder.

There have been a number of companies, for instance, that were able to get the drag on earnings that accompanies development off their balance sheets by joint venturing with institutional investors off balance sheet. As long as that joint venture is not leveraged higher than the parent, this is very effective. It’s effective because the company gets the capital it needs for development, the balance sheet is not burdened by development costs, and bondholders are not impaired because if we were to fully consolidate that venture, the credit statistics are probably unchanged. There are a couple of companies that have successfully employed this strategy.

When do you get concerned by off-balance-sheet activities?

It starts getting problematic from the bondholder’s perspective if off-balance-sheet pursuits are very large in relation to the core business, or if they are very aggressively financed. In those instances, we have to guess at whether management is going to walk from that investment or save their equity investment and pull it all on balance sheet. So what we normally convey to issuers is that we will look at the off-balance-sheet venture and then look at how it’s being financed, whether it’s a long-term core component of their businesses. If it looks like it’s an ongoing, important part of the company’s long-term strategy, we consolidate those ventures on balance sheet.

Are you concerned because REIT prices are down so much this year and companies are shut out of the equity market right now?

When we evaluate a company’s portfolio, one of the things we try to get a feeling for is how that portfolio would weather any market gyrations. So it’s something that we have thought about before it happens. That said, if a company were cut off from the equity market in perpetuity, it would probably restrict its ability to grow its business. I wouldn’t expect that to happen, however. At the same time, there are ways companies can grow even without access to the equity market.

If you think back to the late 1980s and early 1990s, there were a handful of companies that I am sure you are very familiar with that, though much smaller than today’s major companies, had solid portfolios, good management teams, and they didn’t raise a penny for two years. If you go back and look at the cash flows during that time period, those companies didn’t miss a beat because they had internal growth imbedded in their portfolios. When times got tough they hunkered down. They cut costs and they redeveloped assets. In some cases, they used secured financings, but they kept their powder dry and they were among the first to benefit when the recovery began.

What’s your take on current market conditions?

We had a conversation with a REIT investor recently that you might find interesting. What he said is that it’s not inconceivable that REITs should underperform the market at the top of the real estate cycle and outperform the market at the bottom of the cycle because that’s when the companies’ opportunities are the best. My view is that there’s perhaps been an overreaction to the fact that we’re probably at the top of the real estate cycle.

Concern puts it mildly, wouldn’t you say?

Perhaps. But I’m hard pressed to view this as a situation where we see the sky falling for the bulk of the companies we follow. There could be some ratings that become impaired because companies don’t want to curtail their acquisition or development activities, and they cannot continue them without materially altering their financial profiles. But the bulk of the companies we’re following have pretty solid debt service coverage ratios. We would characterize their leverage as modest to moderate, and they have much larger and much more “financeable” portfolios than at any time in the past five to 10 years.

Occasionally, we follow a company that is heavily loaded with secured financing. Those companies could become stressed if they wanted to load up with additional secured financings. But, generally, we have stable outlooks on the bulk of the companies that we follow.

Is there a silver lining to this cloud?

I don’t know about a silver lining, but there are a number of companies that have grown very, very rapidly over the past few years. This period might provide an excellent opportunity for some of those companies to take a breather and to focus on integrating what they have acquired.

There’s been a rather dramatic widening of spreads in the corporate debt market, recently. As a result, some managements have begun discussing the relative merits of the secured vs. the unsecured debt market. Some are suggesting that secured financing may be the best way to go now.

It has got to be a challenge for REIT managements to juggle the near-term benefits of secured vs. unsecured debt at this stage in the cycle. For now, the pricing advantage is in the secured market. My view is that there’s a place for both in a company’s capital structure. A healthy capital structure is one that has an even balance of capital supporting its business. There are, of course, some property types, such as high-quality regional malls, that are more easily financed than others at any given stage of the real estate cycle.

It’s not our place to tell companies how they should finance their portfolios. What we do is evaluate the financial policy the company adopts. Our view, of course, is always the bondholder’s view. Where the secured vs. unsecured debate gets a bit hairy from the bondholder’s perspective is if there’s a lot of secured debt in the capital structure, it could impair the bondholder’s position.

You said it’s not your place to tell companies how to finance their portfolios. But I have heard some CEOs say they sold equity, or whatever, because the rating agencies told them they needed more equity on their balance sheet.

There are situations where issuers give us a heads-up with respect to something they are planning. They may seek feedback from us on how we would view what they have in mind. If we think it would have a negative impact from a credit perspective, we’ll tell them that. If a company chooses to construe that as us telling them what to do, they can take that position. But we don’t act as a financial advisor, and under no circumstances would we tell a company that, for example, it has to sell equity.

What would you say?

What generally happens is that the company’s investment bankers ask us what we think of some new idea they are thinking about presenting to their clients. That happens all of the time. But as I said earlier, it’s not our place to in any way influence a REIT’s policy with regard to its capital structure.

Any other misunderstandings you’d like to dispel?

There is the issue of development and development exposure. There’s the view that the rating agencies tend to look at development as being bad. I don’t think that’s the case. Development has a place in many operating strategies. What we do is look at development and try to determine whether it matches with management’s talents, and whether it’s being pursued at a pace or in a region that fits within the company’s overall strategy.

What about consolidation?

The consolidation that has occurred thus far has, on balance, been credit neutral to a slight positive. Clearly, from a credit perspective, there’s a benefit to companies reaching critical mass. How we view consolidation depends to a large extent on how rapidly an issuer is growing, as well as the depth and caliber of its management team. Bigger can be better, but it’s not always better.