How Public REITs Fund Growth

A public REIT compares the cost, availability, debt capacity and contractual limits of each source, then tests the result on a per-share basis. Borrowing is tested for repayment and refinancing, share issuance for what existing holders own afterward, and asset sales for the income given up. Retained operating cash comes first, because it shrinks the amount that has to be raised externally at all.

The cash bridge: what the external raise has to cover

The amount a REIT raises externally is the cash deficit left after existing obligations, not the purchase price of the next acquisition.

A cash bridge starts with opening unrestricted cash and operating receipts. Distributions, maintenance capital spending, scheduled principal repayments and committed investment spending come off that balance. Net disposition proceeds count only when their closing date supports the spending schedule. What remains is the deficit, and the schedule shows the date by which it must be funded.

Short-term needs such as maintenance spending and scheduled debt repayments are generally met from working capital, operating cash and revolving credit or commercial paper. Longer-term needs are met by issuing debt or equity, by selling assets or joint venture interests, and by operating cash left after distributions.

Gross financing inflows can hide a replacement of existing capital. A note issuance that refinances a maturing note adds no acquisition capacity. An equity offering that supports several uses at once cannot be counted in full against one deal.

Retained cash needs its own reconciliation. Operating cash before distributions is a larger number than cash kept after distributions and recurring property spending, and only the second is free to fund growth. A distribution paid out of asset sales or borrowed money reduces cash available for reinvestment and cannot be counted as retained operating cash.

The menu is wider than debt versus common stock. A REIT can draw on debt, preferred equity, partnership interests and common equity, and the choice turns on relative cost, availability, the debt ratio the company wants to hold and any limit written into its debt covenants.

Relative cost is a comparison at one moment. A company with a low debt ratio, large cash flow and a stable operating profile can issue unsecured notes at attractive pricing relative to peers, which lets it fund external growth mainly with retained cash flow and unsecured notes.

Availability changes the order. In one year a large shopping center REIT raised capital through unsecured term loans and unsecured notes, and also sold common stock at the market, while repaying other notes and term loans. The gross raise and the net new capital were different numbers.

Security is a further variable. Properties with no mortgage on them can support mortgage borrowing if the company chooses it, and pledging one commits the asset and uses up contractual capacity. An unsecured-versus-secured comparison therefore weighs the assets pledged along with the coupon.

Property type does not set a universal target. Apartment, storage, net lease and healthcare REITs draw on the same menu of funding sources, and no property type has a common debt ratio.

Borrowing as a bridge and the takeout that follows

Debt funds growth quickly, and the interest rate on the first draw prices only the bridge.

A revolving facility or commercial paper can close an acquisition immediately. Those borrowings are then commonly replaced with long-term capital such as senior unsecured notes or common stock. The replacement is a second transaction with its own rate and its own market access, and it can differ sharply from the assumption made at purchase.

The sequence has four parts: the draw, the interest burden, scheduled principal and the source that eventually repays the principal. A model that carries the bridge rate to the end of the hold leaves the last two parts unpriced.

Covenants add a separate test. A company-level covenant is computed from the definitions in the financing agreements on the whole balance sheet after the deal. A property-level interest test asks whether one asset pays for its own debt. An acquisition can pass the second and still narrow headroom on the first.

Issuing common stock trades a larger ownership claim for new capital, so the test is what each existing share owns afterward.

Net proceeds per new share equal the issue price minus issuance costs per share. Required equity divided by that figure gives the new share count. Recurring cash after the deal divided by the enlarged share count gives recurring cash per share, which can fall even while total cash rises.

Net asset value per share is a separate calculation. Property value minus debt, divided by the new share count, shows whether issuing below estimated net asset value diluted it. The cash result and the asset-value result use different numerators, and the second depends on the property assumptions behind the estimate.

Some REITs that trade below estimated net asset value lean on free cash flow alongside debt and asset sale proceeds, because issuing shares below NAV dilutes existing holders. One analysis of strip center REITs found that pattern, and the mix varies by company.

An at-the-market program is a channel for selling shares gradually at prevailing prices. A first program can sit beside retained cash and unsecured notes, and it does not show that new shares are cheap capital.

A deep discount combined with a high debt ratio can close the channel altogether. Each dollar of equity then costs many more shares, and lenders may limit more debt.

“Essentially, a REIT at a steep discount and elevated leverage is stuck in a ‘capital box’ whereby it cannot raise new equity or debt to pursue external growth.”
The Cost of Staying Public in a Discounted REIT Market, Chilton Capital Management

Asset sales: cash raised and income surrendered

Selling an asset funds growth with its net proceeds, and the cost is the recurring cash flow that leaves with it.

Net deployable cash equals the gross sale price minus selling costs and any debt that must be repaid to release the property. A large disposition headline can therefore add much less to acquisition liquidity.

Redeploying net proceeds realizes part of the value created in an investment and gives liquidity in place of raising the same amount externally. No new shares are issued. The sold asset and its future cash contribution also leave the portfolio.

The comparison has to use one basis. Cash from the sold property after recurring spending belongs against cash from the acquired property after recurring spending. Setting the sold asset’s cash against the acquired asset’s NOI, before its spending, shows an improvement that is not there.

Timing matters as well. A sale that closes first leaves a gap in income, and an acquisition that closes first needs temporary borrowing. Both effects belong in the cash bridge.

An initial yield on the purchase is one year of NOI over price. It does not measure the effect of the whole sale and purchase on the portfolio.

Worked example: funding a hypothetical $200,000,000 acquisition

The same acquisition is funded four ways and measured over one year. All cases assume no issuance or transaction costs, no taxes, simultaneous closings, interest-only acquisition debt and no added corporate costs. Every figure is hypothetical.

The starting REIT has 100 million shares, property valued at $3,000,000,000 and debt of $1,000,000,000. Estimated net asset value is $3,000,000,000 minus $1,000,000,000, or $2,000,000,000, which is $20 per share on 100 million shares. The debt ratio is $1,000,000,000 divided by $3,000,000,000 multiplied by 100, or 33.33 percent. Annual recurring cash after existing interest and spending is $100,000,000, or $1.00 per share.

The acquisition costs $200,000,000 and earns NOI of $14,000,000. The initial cap rate is $14,000,000 multiplied by 100 divided by $200,000,000, or 7 percent. Recurring property spending is $2,000,000, so cash before financing is $14,000,000 minus $2,000,000, or $12,000,000.

Base case, all debt at 5 percent: interest is $200,000,000 multiplied by 5 divided by 100, or $10,000,000. Incremental cash is $12,000,000 minus $10,000,000, or $2,000,000. Total cash is $100,000,000 plus $2,000,000, or $102,000,000, which is $1.02 per share and a gain of $2,000,000 divided by $100,000,000 multiplied by 100, or 2 percent. Debt rises to $1,200,000,000 and property to $3,200,000,000, so the ratio becomes $1,200,000,000 divided by $3,200,000,000 multiplied by 100, or 37.5 percent. The $200,000,000 of principal still has to be repaid or refinanced.

Coverage depends on the numerator. NOI covers interest by $14,000,000 divided by $10,000,000, or 1.4 times. Cash after recurring spending covers it by $12,000,000 divided by $10,000,000, or 1.2 times.

Stressed debt case, the same borrowing refinanced at 6 percent: interest is $200,000,000 multiplied by 6 divided by 100, or $12,000,000. Incremental cash is $12,000,000 minus $12,000,000, or nothing, so total cash stays at $100,000,000 and cash per share stays at $1.00. NOI coverage is $14,000,000 divided by $12,000,000, or about 1.17 times. Six percent is the breakeven rate, because the acquisition then adds no cash for shareholders.

Equity case at $25 per share: new shares are $200,000,000 divided by $25, or 8000000, and total shares are 100000000 plus 8000000, or 108000000. With no acquisition interest, total cash is $100,000,000 plus $12,000,000, or $112,000,000. Cash per share is $112,000,000 divided by 108000000, a gain of 3.7 percent over $1.00. Net asset value becomes $2,000,000,000 plus $200,000,000, or $2,200,000,000, and $2,200,000,000 divided by 108000000 is $20.37 per share.

Equity case at $16 per share: new shares are $200,000,000 divided by $16, or 12500000, and total shares are 100000000 plus 12500000, or 112500000. Total cash is still $112,000,000, so cash per share is $112,000,000 divided by 112500000, a decline of 0.44 percent from $1.00. Net asset value is $2,200,000,000 divided by 112500000, or $19.56 per share. The same purchase lowers both measures when shares are sold below net asset value.

Asset-sale case: an unencumbered property sells for $200,000,000, funding the purchase in full. It earned NOI of $10,000,000 with $2,000,000 of recurring spending, so the cash given up is $10,000,000 minus $2,000,000, or $8,000,000. Total cash is $100,000,000 minus $8,000,000 plus $12,000,000, or $104,000,000. That is $1.04 per share, an improvement of $4,000,000 divided by $100,000,000 multiplied by 100, or 4 percent. Property value is $3,000,000,000 minus $200,000,000 plus $200,000,000, or $3,000,000,000, so debt stays at $1,000,000,000 and the ratio stays at 33.33 percent.

The sale case adds neither debt nor shares, and it depends on selling at the assumed price and on the income given up. The borrowing cases carry a maturity, and the equity cases depend on the issue price. Each figure is one year of cash. A holding-period return would need every year of cash flow and the ending value.

Funding mistakes that distort acquisition economics

Carrying the bridge rate through the whole model leaves the replacement funding unpriced. The first draw sets closing liquidity, and the later issuance of notes or stock sets a separate cost. If that cost is higher, the apparent spread between the cap rate and the borrowing rate shrinks or disappears, as the breakeven in the example shows.

Treating issuance below estimated net asset value as the whole test confuses asset value with cash generation. The two measures have different numerators, so each has to be computed after the deal. A result can improve on one and fall on the other.

Counting gross sale proceeds as available capital overstates liquidity whenever selling costs or required debt repayment absorb cash. A funding gap also remains between an acquisition closing and a later sale closing, even when net proceeds eventually cover the price.

Comparing NOI directly to a coupon mixes a property income amount with a financing rate. NOI over price is the cap rate, and interest over principal is the borrowing rate. Recurring spending reduces the cash that pays interest, scheduled principal raises debt service, and an interest-only comparison leaves the maturity outstanding.

Relying on property-level coverage leaves company-level restrictions untested. One asset can cover its own interest while the financing agreement’s definitions leave less headroom after the deal than before it.

Reading a gross financing total as growth capital counts refinancing proceeds as new money. A year that shows large issuance and large repayment can have added little net capital.

Checklist: questions for testing a REIT growth funding plan

Does the cash bridge deduct existing obligations before showing cash available for acquisitions?

What repayment source and date apply to each temporary borrowing?

How do issuance costs change net proceeds per new share?

Which covenant limits additional borrowing after the transaction?

How much unrestricted cash does each disposition release?

Are the cash flows of the property sold and the property bought measured on the same basis?

At what replacement borrowing rate does the incremental cash reach zero?

What temporary gap arises if the purchase closes before the planned sale?

Has the funding plan been stressed by raising the replacement borrowing rate, lowering the share price and lowering property values, then rechecking cash per share, net asset value per share and covenant headroom?