The way public property companies manage their capital structure has come under fire from real estate research firm Green Street Advisors. Debt-to-EBITDA multiples are ‘out-of-this-world high’, the firm warns in an interview with PropertyEU.
Pretty much every CFO or CEO of a major listed property company that real estate research firm Green Street Advisors covers knows its forthright views on leverage. For a while now, the firm has been asserting its conviction that debt levels are running too high at most UK and Continental European public property companies - and it claims very few have heeded its warnings.
In its latest the Pan-European Outlook report published on 6 August, Green Street has used no-holds-barred language to make its point. The firm calls the way property companies manage their capital structure ‘irresponsible’ and - in equally plain language - argues that debt-to-EBITDA multiples are ‘out-of-this-world high’.
These reprimands may come as something of a surprise to the casual observer of real estate because the consistent message coming from commentators and those at conferences is that lessons were learned from the last downturn, the Global Financial Crisis of 2008. The received wisdom is this time is different. This time, there is no high leverage in the system and by all measures, the use of debt is conservative and in no way can lead to a re-run of the problems seen in the aftermath of 2008.
However, Green Street is steadfastly challenging attitudes towards debt. Its detractors respectfully describe it as having a long-standing ‘gripe’. After all, the advisor has been making the same point since at least 2014 when it said most companies it covered had debt around the same level as at year-end 2006. It all begs the question ‘who is right?’ - and if Green Street is right, when will that be proved? The answer is probably only when (not if) there is another downturn.
Historic data analysis
Peter Papadakos, managing director of Green Street Advisors and lead research analyst in Europe, says he is frustrated by the way listed companies seem to be ignoring its warnings, which he ascribes partly to companies not being in possession of the same historic data that his firm has. The company has been analysing data on REITs and public property companies from the late 1980s onwards, since when there have been many significant downturns allowing it to assess the optimal capital structure of public companies.
The basic question is: when does having higher leverage lead to better shareholder returns and above which level is it more likely that companies will suffer during a downturn leading to negative shareholder total returns? When does the negative effect of leverage effectively outweigh any upside enjoyed during the good times? Or, put another way, what level of leverage at the peak of a cycle ends up creating significant problems either through forced sales or equity rights placements or issues at precisely the wrong time, i.e. when values are at their lowest?
For public companies, Green Street Advisors has found that higher leverage has not been associated with stronger returns during the recent recovery. The statistical relationship between the two metrics has been approximately zero, it says, and Green Street’s best explanation for this is that lower-quality companies are often associated with higher debt levels perhaps as they try to post eye-catching cash flow growth despite less underlying value creation than their best-in-class peers.
Leverage in good and bad times
‘We have plenty of data that is pretty clear-cut and simple as far as we are concerned,’ says Papadakos. ‘With the costly benefit of hindsight, investors now know just how much trouble even a high quality listed real estate company can get into with a leverage ratio of “only” 40% ahead of a severe financial crisis, both in terms of destruction of existing value through distressed sales/recapitalisations and lost opportunities to buy new assets cheaply.’
He adds: ‘We see no evidence that higher-than-average leverage helps companies, on average, in the up-cycle. Yet most companies in our coverage universe have debt levels about the same as year-end 2006.’
Green Street’s study of debt levels in 2007 shows that although there is no evidence of benefits from leverage in the good times, in bad times it can cause ‘annihilation’. ‘The years 2009 and 2010 proved to be the bottom of property values and those companies that had leverage of more than 35% in June 2007 got crushed,’ argues Papadakos. Two pertinent examples are Germany’s IVG Real Estate that fell into the hands of creditors in 2014 and Italy’s Pirelli Real Estate. Another would be Land Securities in the UK.
In 2007, UK propcos had leverage in the mid-to-high 30% band. Land Securities was at 37%, which one would think represents a strong balance sheet, but it ended up having to organise a rescue rights issue in 2009. At the time, no-one really knew in which direction property values were going. ‘It was not that far from breaching covenants,’ recalls Papadakos. ‘Lenders said they would not refinance loans unless it raised more equity and sold real estate at the precisely the wrong time, which ended up with total shareholder returns coming close to zero.’ On the flip side, companies such as Unibail-Rodamco-Westfield went into the downturn with 25% leverage and remained largely unscathed.
Green Street Advisors acknowledges most companies have made good progress in other important areas, like extending maturities, increasing room under covenants and diversifying financing sources, but it still sees loan-to-values as a good benchmark for assessing a management team’s philosophy.
Land Securities, referred to earlier by Papadakos, seems now to be among the companies that are operating with much lower leverage. Responding to PropertyEU’s request for comment, the UK major said: ‘Landsec have always had a disciplined approach to balance sheet management and our last reported loan to value was modest at just under 26%’.
UK versus Continental Europe
Green Street says Continental Europe’s public property companies are more highly leveraged than UK firms on two measures (see chart): overall leverage and debt to EDITDA, so its warning is directed more at those on the Continent. It says leverage below 30% is more appropriate for the REIT structures and asserts that many UK companies are well positioned for any Brexit-induced spike in real estate volatility. However, Continental property companies are ‘ill prepared.’
EPRA, the European Public Real Estate Association, told PropertyEU that while the issue was ‘interesting’ it was not something it was in a position to comment about. But it did refer those that are interested to its Monthly LTV Monitor which shows index constituents have a weighted average loan-to-value ratio of 37.05% as of July 2018.
Property companies do have the benefit of low borrowing costs. However, it could be argued that low borrowing costs signals interest rates are low because economic growth prospects are also low. Papadakos suggests the benefit of low borrowing costs is over, as most companies have refinanced over the past four or five years. His advice is they should now be thinking about the next few years and not rely on low cost of debt to deliver shareholder returns. ‘Most people now expect interest rates to be a headwind as they slowly creep up after several years of capital value growth. What we think will happen, is that when we get to the down cycle we will see companies materially underperform.’
This is an ongoing debate with the CFOs of Europe’s property companies, especially with the 24 firms Green Street covers. ‘They all know and respect Green Street has very strong views on leverage but are comfortable operating at these levels,’ says Papadakos. ‘But then again, they don’t have the data, which is frustrating for us.’
It is possible that a proportion of existing CFOs at Europe’s public property companies would not have been in place during the last downturn. Indeed, Papadakos cannot think of any that were.
But aside from that, the finger of suspicion might also be pointing at the way senior management figures are remunerated. Papadakos says that historically in Europe, CFOs have not had a shareholding-weighted remuneration package. Typically, the remuneration would be a base salary and a cash bonus rather than being paid in stock that has to be held for a certain amount of time. ‘Senior management is therefore more aligned with bondholders who the company owes money to than equity holders who stand to feel the pain in a downturn.’
Green Street Advisors does not have remuneration data relating specifically to CFOs. However, it has studied equity ownership of CEOs as a multiple of base salary and believes there is a marked difference between the US and Europe. In the US, equity to salary multiples have stood at 25x, while in the UK it is 5x and on the Continent 4x. Up until two years ago, it was less than 1x and virtually zero on the Continent. Papadakos does feel happy that the multiples have gone up, but there is no external pressure to delever and he has no reason to believe management teams will ‘have an epiphany and do it themselves’.
Debt to EBITDA
The company’s focus is not just on overall leverage but also on debt to EBITDA. The latter is not usually looked at for property companies but this measure of a company’s capacity to repay its debt is used as a key metric in most other industries where they do not have such valuable tangible assets like real estate. Companies in most other industries have debt to EBITDA multiples of between 1 and 3x. But real estate companies tend to operate above 5x and feel they can do that because of the dependable cash flow from rents.
Green Street nevertheless says this is ‘off-the-chart’ compared to other industries or indeed propcos in other regions. For instance, the firm’s latest US Weekly REIT pricing sheet shows that the US leverage ratio average is 32.3% as opposed to 44% on the Continent, and the debt/EBITDA multiple is 5.7x in the US as opposed to 10.8x in Europe.
The ‘right’ number depends on the type of property company. A company with significant development activity that is not generating much rent yet might have a higher debt to EBITDA multiple than a company, say, with lots of income-producing assets. Companies with overall leverage of 20-30% would tend to have debt to EBITDA multiples of 5x-7x. ‘That kind of number probably makes sense but not much more,’ says Papadakos. For some companies that have lots of developments but also high-quality income-producing real estate, debt-to-EBITDA could be 12x-16x. To those that would argue asset sales can simply help address any imbalance of an overly risky position, Green Street says in a downturn this can be adverse, and anyway, selling income-producing assets will cut income and therefore EBITDA so the multiple might not fall as quickly as one might wish for.
Heeding Green Street’s advice would be harder for property companies now than two years ago. Most REITs were trading at a premium to NAV from 2015 to 2016 at a time when the ECB was supporting economies. Equity issuance could be achieved without diluting shares. Today, these companies are trading at discounts, so the equity window is more shut than open. The only way that wouldn’t dilute shareholder value today would be disposals of assets, but there are problems with that of course, not least of which is that companies would need to sell a lot of real estate to reduce leverage by 10 or 15%, and this cannot be done overnight. The other avenue available is to slow down the growth of dividends and retain more earnings.
In Green Street’s view, not only should leverage be reduced to insulate companies against the nasty effects of a downturn, but those companies that have low levels could prosper. They might be able to buy well when others are in trouble.
Green Street is a bit of an outlier in its attitude towards debt. That said, it has noticed more consensus building among analysts about aggressively using debt at a time when interest rates are rising. But it is not only analysts that are expressing concern. Richard Dakin, a non- executive director at Derwent Valley and managing director of CBRE Capital Advisors, says some care needs to be taken by the lenders. ‘All in all, lending standards are quietly loosening in commercial property, in the UK and across Europe, meaning that the record level of capital chasing exposure to the sector should tread carefully,’ he says.
CBRE’s research says loan-to-values have edged up from 55% to 60%, while margins have gone from 1.40% to 1.50% and the total cost of debt has also increased from 2.52% to 2.92% thanks to rising interest rates. He warns against complacency and suggests lenders are actually taking on more risk.
Papadakos concludes: ‘Our point is simple. Now that the capital markets are okay and the private markets are also good with a lot of liquidity, companies should be thinking about positioning their balance sheet in a way that leaves them in a good position for when the property market turns. They shouldn’t leave it until it is too late.’
The listed property company’s view
Citycon, the Nordic shopping centre specialist, is both a member of EPRA and features on Green Street Advisors’ coverage list. It has a €4.5 bn portfolio and a loan-to-value ratio of 47.0% as at the end of June. It has strengthened its balance sheet since 2011 when its loan-to-value figure stood at around 58%. ‘One of our long-term financial targets is to have leverage in the range of 40-45%, meaning we are slightly above the target range at the moment,’ says Mikko Pohjala, head of investor relations. ‘Reducing leverage is a key priority for us and, as a result, we plan to divest 5-10% of our assets in the coming few years to strengthen our balance sheet and to be within our loan-to-value target range.’
He adds: ‘When analysing the loan-to-value ratios of different real estate companies, one should always take into account differences between business models and countries of operation and whether there is a REIT system in place. Citycon’s business model is based on necessity-based tenants (groceries, medical services, municipal services), which are more resilient to online shopping. In addition, we operate in the Nordics, which provide an extremely stable operating environment. Compared to Continental Europe, the leverage levels in the Nordics have typically been higher due to the stable environment and as there is no REIT system in place.’