Capital Markets Uncertainty Spurs Borrowing Blues for REITs — BDO Study

May 2016

Kathryne Hunter
Bliss Integrated Communication

Tax Reform Brings Mixed Bag for Real Estate Industry

CHICAGO – May 24, 2016 – While a strong mix of economic fundamentals has propelled REIT performance back from a soft start to 2016 to outperform the broader market, turbulence in the bond markets along with a mercurial stock market is tempering optimism. According to a new report by BDO USA, LLP, a leading accounting and consulting organization, risks related to indebtedness are cited by 96 percent of REITs in their most recent annual filings, up from 92 percent in 2015 and 75 percent the year before. This trend is motivated by a large portion of the REIT market continuing to trade at a discount to net asset value, volatility in the CMBS market as well as conservatism in the public bond markets.
The 2016 BDO RiskFactor Report for REITs, which analyzes the latest 10-K filings for the largest 100 publicly traded U.S. REITs, reveals that REITs also worry they may be unable to raise the capital required to finance assets and drive business growth. Access to capital, financing and liquidity remains a top concern this year, cited by 96 percent of REITs. Credit risk, including concerns around credit rating and the ability to secure credit, is cited by 87 percent, up from 80 percent in 2015 and 55 percent the year before.
“The industry is watching warily as ongoing turmoil dominates the domestic and global markets ― paying special attention to the Federal Reserve and hints as to when it may raise interest rates further,” said Stuart Eisenberg, partner and national leader of BDO’s Real Estate practice. “REITs worry about the potential impact of a rate hike on the value of income-producing real estate or that it might spur lenders to seek out higher loan-to-value ratios or debt yield requirements. Overall, REITs are eyeing the credit markets with a heavy dose of caution.”

The following chart highlights the top 20 risk factors cited by the 100 largest U.S. REITs:
Rank Risk Factor Cited in 10-K 2016 2015 2014 2013 2012
#1t Risks associated with general and local economic conditions including disruptions in the financial markets, lack of demand 100% 100% 100% 100% 100%
#1t Failure to qualify as REIT and loss of tax incentives; ability to make distributions 100% 100% 100% 100% 100%
#1t Strong competition for lessees, prime real estate; consolidation in industry 100% 98% 94% 96% 93%
#4 Environmental liability 99% 92% 89% 90% 91%
#5t Increases in interest rates; hedging 98% 97% 90% 88% 92%
#5t Federal, state or local regulations 98% 93% 86% 85% 94%
#7 Natural disasters, health epidemic, terrorism and geo-political events; climate change 97% 92% 85% 90% 83%
#8t Access to capital, financing and liquidity 96% 99% 93% 94% 97%
#8t Insurance: self, credit, cost, potential losses due to uninsured liabilities 96% 95% 87% 87% 86%
#8t Debt/financial covenant restrictions 96% 95% 83% 76% 79%
#8t Risks related to indebtedness 96% 92% 75% 85% 90%
#12t Tax laws and increases in rates 94% 99% 85% 83% 79%
#12t Risks associated with mergers and acquisitions, joint ventures and partnerships 94% 97% 85% 82% 90%
#14 Operating expenses and costs of capital improvements and renovations 93% 88% 82% 77% 80%
#15 Risks associated with a possible security breach resulting in the release of confidential customer, employee and corporate information 91% 89% 63% 39% 25%
#16 Inability to sell properties quickly due to illiquidity of real estate investments 88% 93% 89% 82% 89%
#17 Credit risk (rating, extension of, fraud, red flag) 87% 80% 55% 38% 53%
#18 Development and construction risks (permits, costs, abandonment) 86% 80% 69% 70% 72%
#19 Risks associated with anti-takeover provisions; change of control 85% 82% 86% 80% 84%
#20 Tenants may be unable to pay rent; financial condition of tenant; unemployment 83% 78% 79% 75% 71%

Additional findings from the 2016 BDO RiskFactor Report for REITs include:
Tax Reform Takes Center Stage 
Signed into law in December 2015, the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) contains a number of provisions likely to have a significant impact on REITs. While some of these changes will be favorable, all will add to the complexity of maintaining REIT status and satisfying the various compliance and reporting obligations REITs face. Failure to maintain REIT status or loss of tax incentives remains a top risk, with 100 percent citing concerns for the fifth year running. Other new accounting rules, like the Financial Accounting Standards Board's new lease accounting standard, could be contributing to the 69 percent of REITs that cite worries around accounting rule changes and financial reporting risks.
Fraud, Cybersecurity Threats Contribute to Uninsured Liability Risk 
Ninety-one percent of REITs note security breaches as a risk this year, a figure that has more than tripled since 2012. According to a report released by PhishLabs, Business Email Compromise/Correspondence (BEC) attacks, a form of phishing attack, grew significantly in 2015. REITs could be especially susceptible to wire transfer fraud via BEC attacks, in which fraudulent emails seek to trick employees into sending funds to bank accounts set up for such purposes. These types of attacks can result in significant financial loss ― wire transfer amounts in the hundreds of thousands of dollars are not uncommon. The growing phishing threat and broader cybersecurity issues may be contributing to an increase in mentions of uninsured liabilities, cited by 96 percent of REITs.
"Even organizations with the most sophisticated cybersecurity technology remain vulnerable to attack if they don't account for the human element," said Shahryar Shaghaghi, National Leader, Technology Advisory Services and Head of International BDO Cybersecurity. "Organizations need to put as much emphasis on cyber policies and procedures – as well as training their employees on how to follow them – as they do on cyber technology."
Influx in Foreign Investment Creates Squeeze 
Sixty-three percent of REITs cite impediments to their U.S. expansion and growth, including risks related to operations, strategy execution and securing real estate, a figure which has more than doubled since 2014. Significant capital inflow from wealthy foreign investors, looking for safety from instability in their home markets and drawn to the consistent returns and prestige of U.S. real estate assets, could be squeezing the marketplace. This trend is likely to persist, thanks in large part to provisions in the PATH Act that lower barriers for non-U.S. investors. It’s worth noting, however, that large deals can raise a number of regulatory flags, both stateside and abroad, which has led to an uptick in reviews by the Committee on Foreign Investment in the U.S. (CFIUS).
The 2016 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.
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