Fitch: Covenants Ready to Shield US REIT Bonds from M&A Risk

NEW YORK--(BUSINESS WIRE)-- The recent announcement that Excel Trust, Inc. agreed to be acquired by an affiliate of Blackstone Property Partners, L.P. in an all-cash transaction valued at approximately $2 billion should serve as another litmus test on whether certain features inherent in REIT bonds protect investors from merger risks, according to Fitch Ratings.

In connection with the closing of the transaction, Excel Trust, L.P.'s$75 million of 4.40% senior series A notes due 2020 and its $25 million of 5.19% senior series B notes due 2023 will be repaid. The surviving company, BRE Retail Properties, currently plans to leave Excel Trust, L.P.'s$250 million of 4.625% senior notes due 2024 outstanding following the closing. Excel Trust, Inc.'s 7.00% series A cumulative convertible perpetual preferred stock and its 8.125% series B cumulative redeemable preferred stock will be redeemed.

The range of possible implications for bondholders from REIT privatizations are broad and can include bond tenders, consent payments, and credit downgrades. The acquirer's investment objectives and interactions with bondholders often determine the outcome, making it challenging to handicap.

However, REIT bonds enjoy some key structural attributes that offer bondholders better prospects for tenders at a negotiated price relative to other investment-grade corporate bonds. These attributes have often enabled REIT bondholders to extract significant value from acquirers by essentially holding a blocking position to the completion of the transaction.

In acquiring public REITs, many private equity buyers plan to increase leverage and reduce overhead costs to improve equity returns. Thus, few leveraged buyers will want to operate the company with either the leverage constraints or the reporting standards necessary to comply with SEC requirements contained in REIT bond indentures. Private equity firms have little choice other than to negotiate with bondholders to tender for the bonds at premiums and eliminate reporting requirements via consents. These provisions have shield many REIT bondholders from the fate of fixed-income investors in other corporate sectors who become subject to highly levered borrowers and a less certain strategy.

REIT bond indentures contain language that prevent REIT Operating Partnerships (the bond issuing subsidiaries of most REITs) from being acquired unless all of the bond obligations are assumed by the new owner. Examples of these provisions include financial covenant protections, yield maintenance provisions, and reporting requirements associated with publicly registered securities.

Non-call features embedded in most REIT bonds are at the core of bondholder protections. REIT bond terms generally prohibit prepayment without yield maintenance to insure predictable yields for investors. Consequently, it is often challenging and very expensive, to repay outstanding bonds of an acquired REIT.

Language requiring the bond issuer to survive as a legal entity contained in most REIT bond indentures is another essential bondholder protection. This provision restricts acquirers from dissolving bond issuers unless all of the bond obligations are assumed by the acquiring entity, thereby ensuring that the terms agreed to in the bond indenture continue to be the specific responsibility of the surviving entity.

Alone, the above protections have done little to comfort investors holding bonds issued by investment grade-rated companies that are acquired in highly leveraged transactions. However, when combined with the strong financial maintenance and incurrence covenants contained in REIT bond indentures, REIT bondholders have been sheltered from many of the pitfalls of merger and acquisition activity that have befallen investors in other industrial corporate bonds. Historically, most public-to-private merger activity has involved the levered acquisition of public REITs and most of these companies, pre-acquisition, carried modest amounts of leverage and boasted substantial pools of unencumbered assets.

Financial covenants provide REIT investors with significant downside protection by limiting the incurrence of additional debt. The covenant levels contained in REIT bond indentures often implicitly help prevent credit profiles from deteriorating below the 'BB' rating level. 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. Although subsidiary lenders may be structurally senior to parent company lenders, any effects of substantive consolidation in bankruptcy would eliminate these benefits to REIT bondholders.

Similar financial covenants are unusual in the high grade bond market, but are common to bonds issued by below investment grade-rated companies. REIT issuers began to operate their businesses within the parameters of four basic financial covenants in order to gain access to wider support from bond investors when they first approached the unsecured debt markets over 20 years ago.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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Fitch Ratings

Stephen Boyd, CFA

Director

U.S. REITs

+1 212-908-9153

Fitch Ratings, Inc.

33 Whitehall Street

New York, NY 10004

or

Steven Marks
Managing Director

U.S. REITs

+1 212-908-9161

or

Kellie Geressy-Nilsen
Senior Director

Fitch Wire

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