As Risks Related To Interest Rates Grow REIT Rally Could Be Cut Short, Reveals BDO Study

May 2015

Emily Dell
Bliss Integrated Communication
212-584-5483
emily@blissintegrated.com

Chicago – May 20, 2015 – As the overall economy continues to accelerate, so too does the demand for REITs. However, this may diminish if interest rates rise. According to a report by BDO USA, LLP, a leading accounting and consulting organization, 97 percent of REITs mention risks related to increases in interest rates and hedging. This is up from 90 percent in 2014 and 88 percent in 2013, according to the 2015 BDO RiskFactor Report for REITs, which analyzes the most recent SEC 10-K filings for the 100 largest publicly traded REITs in the U.S.
 
“Low interest rates have contributed to the REIT industry’s expansion in recent years, and if an increase in interest rates were to occur, the industry’s access to capital to fund future growth may be impacted,” said Stuart Eisenberg, partner and Real Estate practice leader at BDO. “However, this could be offset by both strong economic fundamentals and a lack of attractive alternative investments that provide an acceptable risk adjusted return.”
 
The low rates, coupled with greater demand, could be responsible for the robust M&A activity the industry is experiencing. And with more M&A activity comes greater risks. Nearly all REITs (97 percent) mention risks associated with mergers and acquisitions, joint ventures and partnerships in the report, up from 85 percent in 2014.
 
“REITs are eager to grow their portfolios through M&A activity especially as interest rates remain low. However, with such high demand and not enough quality product, many REITs are taking a differentiated approach to securing additional properties,” said Anthony La Malfa, partner with BDO’s Real Estate & Hospitality Services group. “Many REITs are chasing deals and choosing to round out their portfolios with properties in secondary and tertiary markets and others are using innovative deal structures to remain active in their focused markets.”
 
As the mention of risks related to M&A transactions grows, so too does the mention of tax laws and rates. This could be a result of the tax issues that can emerge during M&A transactions and the importance of understanding tax implications. Ninety-nine percent of REITs mention tax laws and increases in rates as a risk, up from 85 percent in 2014. Additionally, mention of risks related to internal controls, financial reporting and accounting rule changes also continues to rise, with 73 percent of REITs citing it as a risk this year, up from 50 percent in 2014, and 36 percent the year before. These findings align with BDO’s inaugural Tax Outlook Survey of 100 tax directors at $1 billion-plus public companies. Forty-five percent of respondents say uncertainty about foreign, federal and state tax legislation is the primary tax issue they face at this time.
  
The following chart highlights the top 25 risk factors cited by the 100 largest U.S. REITs:
 
2015 Rank Risk Factor Cited in 10-K Filing 2015 2014 2013 2012
#1 Risks associated with general and local economic conditions including disruptions in the financial markets, lack of demand 100% 100% 100% 100%
#1t Failure to qualify as REIT and loss of tax incentives; ability to make distributions 100% 100% 100% 100%
#3 Access to capital, financing and liquidity 99% 93% 94% 97%
#3t Tax laws and increases in rates 99% 85% 83% 79%
#5 Strong competition for leasees, prime real estate; consolidation in industry 98% 94% 96% 93%
#6 Increases in interest rates; Hedging 97% 90% 88% 92%
#6t Risks associated with mergers and acquisitions, joint ventures and partnerships 97% 85% 82% 90%
#8 Insurance: self, credit, cost, potential losses due to uninsured liabilities 95% 87% 87% 86%
#8t Debt/financial covenant restrictions 95% 83% 76% 79%
#10 Inability to sell properties quickly; due to illiquidity of RE investments 93% 89% 82% 89%
#10t Federal, state or local regulations 93% 86% 85% 94%
#12 Environmental liability 92% 89% 90% 91%
#12t Risks related to Indebtedness 92% 75% 85% 90%
#14 Natural disasters, health epidemic, terrorism and geo-political events; climate change 90% 85% 90% 83%
#14t Risks associated with payments of common and preferred stock; suspension 90% 85% 68% 68%
#16 Risks associated with a possible security breach resulting in the release of confidential customer, employee and corporate information 89% 63% 39% 25%
#17 Operating expenses and costs of capital improvements and renovations 88% 82% 77% 80%
#18 Risks associated with anti-takeover provisions; change of control 82% 86% 80% 84%
#19 Property foreclosure; bankruptcy 80% 73% 65% 37%
#19t Development and construction risks (permits, costs, abandonment) 80% 69% 70% 72%
#19t Credit risk (rating, extension of, fraud, red flag) 80% 55% 38% 53%
#22 Tenants may be unable to pay rent; financial condition of tenant; unemployment 78% 79% 75% 71%
#22t Declines or stagnation in the values of business and real estate values; asset impairment 78% 74% 70% 65%
#24 Loss of key management personnel (CEO, Chairman, etc.); new key personnel, new leadership 75% 76% 67% 68%
#25 Internal controls and financial reporting risks, accounting rule changes 73% 50% 36% 46%
#25t Legal proceedings, litigation 73% 40% 38% 53%
“t” indicates a tie in the risk factor ranking

Additional findings from the 2015 BDO RiskFactor Report for REITs include:
 
  • Business Interruptions Drive Insurance Concern. Similar to previous years, threats of terrorism, civil unrest, climate change and natural disasters are on the rise. This year’s record-breaking snowfall in Boston reached 110.6 inches, according to Weather.com. On the other side of the country, California is in the midst of its worst drought in 1,200 years, according to Business Insider. These events could hamper demand and land value and slow real estate development projects. This may be why 90 percent of REITs note natural disasters, war, conflicts and terrorist attacks as risks. Such sentiment may also be contributing to a rising concern around inadequate insurance, with 95 percent citing this as a risk, up from 87 percent last year.
 
  • Cybersecurity Threat on the Rise. With recent cyber attacks on major companies such as Primera Blue Cross, Home Depot, JPMorgan Chase and Sony Pictures, it is clear that this growing threat is top-of-mind for companies across industries. The REIT industry invests in assets across many sectors and is paying close attention. This year, 89 percent of REITs cite security breaches as a concern, up from 63 percent last year, and 39 percent in 2013. Not only is confidential information at stake in a potential attack, but also the financial cost of remedial actions and the REIT’s reputation. In fact, this could be the reason why legal proceedings and litigation is growing as a risk. The risk is mentioned by 73 percent of REITs, up from 40 percent in 2014.
 
  • Competition Risk Raises Expansion Issues. REITs’ concern over mergers, acquisitions, and joint ventures is being fueled by increased worry around competition for prime real estate, with 98 percent of REITs citing it as a risk, up from 94 percent last year. Not only is the competition for attractive assets leading more REITs to consider alternatives to acquisitions in primary markets, but acquiring or partnering with other companies in joint ventures is becoming a more competitive process as well. REITs are taking creative approaches to acquisitions and joint ventures, with some of the larger REITs focused more on consolidation. Related to expanding and enhancing asset portfolios is property development and construction activity, which saw an increase to 80 percent noting it as a risk this year, up from 69 percent the year before, which could be attributed to growing amount of development by REITs.
 
  • Environmental Liability Fuels Renovation Concerns. The number of REITs citing operating expenses and costs of capital improvements has been steadily increasing, with 88 percent noting it as a risk this year, up from 82 percent last year, and 77 percent in 2013. REITs could experience financial losses if their rental income and operational costs diverge too dramatically. Additionally, the cost and timing of renovations could be burdensome and might not result in desired returns. Intensifying the concern around such capital improvements is the increasing number of environmental standards for newly renovated properties. This may be why 92 percent of REITs cite environmental liability as a risk, up from 89 percent last year.
 
The 2015 BDO RiskFactor Report for REITs examines the risk factors in the most recent 10-K filings of the largest 100 publicly traded U.S. REITs; the factors were analyzed and ranked by order of frequency cited.
 
About BDO
BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through 58 offices and more than 400 independent alliance firm locations nationwide. As an independent Member Firm of BDO International Limited, BDO serves multi-national clients through a global network of 1,328 offices in 151 countries.

BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.