Recent Amendment Trends for REIT Credit Facilities
The onset of the novel Coronavirus pandemic (“COVID-19”) led to an abrupt shutdown of businesses worldwide and across numerous industries. The shutdown’s impact on the commercial real estate market generally, and on REITs specifically, was significant as demand for leased space diminished and tenants struggled to pay rent. Furthermore, certain REIT sectors such as office, lodging/hotels, student housing and retail experienced immediate negative effects as a result of travel bans, work from home mandates and social distancing requirements. While navigating this economic uncertainty, REITs have a special consideration as they balance their ability to meet their mandatory distribution requirements while maintaining sufficient liquidity to support operations in capital intensive businesses. Fortunately, REITs came into 2020 in overall good financial health with strong balance sheets and relatively low leverage. As the duration and scale of COVID-19 remains unknown and continually evolves, REIT borrowers are working with their senior lenders to waive defaults where applicable and amend their existing credit facilities to allow for greater flexibility to weather the pandemic. The credit facility amendments from the second quarter of 2020 for many REITs included many of the following modifications and additions.
I. FINANCIAL COVENANT MODIFICATIONS
Numerous amendments in the second quarter of 2020 provided borrowers with flexibility with respect to their financial maintenance covenants. For a majority of REITs, financial covenants, including leverage ratios and fixed charge and/or debt service coverage ratios, were either modified or waived until the first or second quarter of 2021. These covenant waivers were often accompanied by greater negative covenant restrictions and increased pricing for the duration of such waiver periods and often included the option for the borrower to terminate the financial covenant waiver period along with the added covenant restrictions upon achievement of pre-agreed levels of financial covenant performance. Given the difficulty in projecting when the impact of COVID-19 on normal operations and revenue will subside, this flexibility is critical to borrowers as it allows them to reset a fair amount of their credit agreement restrictions and pricing to pre-COVID-19 terms in the event such borrower’s financial performance metrics improve earlier than the currently negotiated outside financial covenant waiver date.
Many amendments included a phased return to pre-amendment covenant levels extending into the third quarter of 2022. During this phased return period, lenders and borrowers have agreed to a modified methodology of calculating the underlying components of the applicable financial covenants, including the annualization of EBITDA, net operating income and/or asset value. The annualization of these components ensures that such amounts are more reflective of typical business performance, minimizing, where possible, the disruptions caused by COVID-19.
II. MINIMUM LIQUIDITY TESTS
In exchange for the waiver of existing financial covenants, lenders added minimum liquidity covenants to serve as a near term measurement of a borrower’s financial condition. These minimum liquidity tests most often measure the sum of cash on hand and available revolving credit facility commitments. In addition, lenders increased reporting requirements with respect to the liquidity covenant and requiring certification of compliance with the minimum liquidity covenant on a quarterly or even weekly basis.
These liquidity tests are a helpful indicator for lenders in the current environment. As opposed to the financial crisis of 2008, REITs entered the pandemic in a strong position having maintained substantial unused lines of credit and sufficient capital. In March of 2020, REITs had nearly $120 billion in untapped lines of credit11 John Worth, REITs Prepared for Coronavirus with Cash and Lines of Credit, NAREIT (Mar. 20, 2020), https://www.reit.com/news/blog/market-commentary/reits-prepared-coronavirus-cash-and-lines-credit.. Additionally from 2010 through 2019 REITs raised $440 billion of equity capital which resulted in lower leverage coming into the challenges of COVID-192Calvin Schnure & John Barwick, REIT Access to Capital Maintained During Pandemic, NAREIT (July 10, 2020), https://www.reit.com/news/blog/market-commentary/reit-access-capital-maintained-during-pandemic.. As a result of cashflow disruptions and economic uncertainty, REITs have taken steps to secure liquidity as a precautionary measure. In the first quarter of 2020, REITs drew down $37.19 billion from their revolving credit facilities3Chris Hudgins, US REITs Draw Down $37B from Revolving Credit Facilities in Q1, S&P GLOBAL (June 12, 2020), https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/us-reits-draw-down-37b-from-revolving-credit-facilities-in-q1-59004198.. Accordingly in the second quarter of 2020, many REITs had a significant amount of cash on their balance sheets and therefore lenders focused on measuring that liquidity as an important metric of the REIT borrower’s financial condition. As prolonged social distancing measures continue, REITs will continue to experience income stream disruptions requiring them to maintain sufficient liquidity and therefore access to the debt capital markets will remain vital.
III. NEGATIVE COVENANT LIMITATIONS
As noted above, in exchange for certain financial covenant waivers and modifications, lenders requested increased negative covenant restrictions. These included restrictions on additional indebtedness, investments, dispositions, capital expenditures and dividends and distributions. Given the requirement that REITs must distribute at least 90% of taxable income to investors through dividends to maintain REIT status under the Internal Revenue Code, the limitations on REIT dividends during the waiver period are different from that of non-REIT public companies. A majority of amendments limited the borrower’s ability to pay distributions on common shares to the payment of cash distribution of $0.01 per common share per quarter or the amount otherwise required to maintain qualification for taxation as a REIT. Notably, since the beginning of the pandemic, REIT dividends are down 20%. Thirty-six REITs have already suspended their dividends and twenty-six have made cuts4Lawrence C. Strauss, After 20% Plunge, REIT Dividends Appear to Have Bottomed Out. Here are 9 JPMorgan Analysts Like., BARRONS (July 10, 2020), https://www.barrons.com/articles/after-20-plunge-reit-dividends-appear-to-have-bottomed-out-here-are-9-jpmorgan-analysts-like-51594375201..
As lenders tighten covenants in exchange for financial covenant flexibility, one area of significant focus has been adding controls on capital expenditures. Many amendments have increased restrictions on discretionary capital expenditures in order to insure that liquidity remains available to REIT borrowers to fund operating expenses as the pandemic progresses. A common approach has been to permit emergency, life safety and ordinary course maintenance expenses without a limit but to include the addition of dollar caps on discretionary and other capital expenditure spending.
While many REIT facilities remain unsecured, another trend in the 2020 second quarter amendments was the requirement of a pledge of subsidiary equity in exchange for the financial covenant waivers discussed above. Some pledges are required at the time of the applicable amendment and others added “springing” pledges that are tied to leverage and/or liquidity based triggers. In many cases, where pledges have been added in the second quarter amendments, such amendments also provide for the ability for borrowers to request the release of such collateral upon attaining certain required de-leveraging thresholds.
Another significant focus of lenders in these recent REIT amendments is the addition of mandatory prepayments. These concepts, while fairly common in leveraged loan facilities, are not as typical in REIT credit facilities but are being added as further protections for lenders in this environment. These provisions require the borrower to prepay its credit facility with the proceeds of various transactions including asset dispositions, other debt issuances and certain equity issuances. Per these amendments, in the event such borrowers are able to access the capital markets or otherwise consummate a sale or other transaction resulting in net proceeds, lenders want to insure that all or a portion of such proceeds reduce the outstanding exposure under the applicable credit facility. These provisions are often only applicable during the financial covenant waiver period. Interestingly, in many deals, there is a balance between insuring the borrower maintain a certain minimum liquidity while at the same time, insuring that they are not hoarding an excess amount of cash on the balance sheet by requiring a prepayment of outstanding loans in the event cash on hand exceeds a certain agreed threshold.
IV. MATERIAL ADVERSE EFFECT CARVE OUT
Borrowers in need of financial covenant, payment or other relief over the last quarter were faced with the issue of whether they could bring down the representations and warranties in their credit facilities as would normally be expected in an amendment or consent scenario. Of specific concern for REIT borrowers was the ability to bring down the no Material Adverse Effect representation. For many REIT borrowers, in order to continue to make the representations and warranties in their credit facilities on the closing date of the applicable amendment and on an ongoing basis thereafter, it was imperative that the definition of Material Adverse Effect be amended to exclude the effects of COVID-19. These modifications varied across deals but the overall effect was the same which was to carve out any event or circumstance resulting from the COVID-19 pandemic to the extent that such event or has been disclosed in writing by the borrower to the lenders or in the borrower’s securities filings prior to the date of the amendment in question. Most often such carve out required that the scope of such adverse effect is not materially greater than that which has been disclosed prior to the applicable date of the amendment. This Material Adverse Effect carve out is essential in order for borrowers to bring down their representations and warranties in connection with future advances on their existing revolving credit facilities.
In conclusion, as the impact of the COVID-19 pandemic is continuing longer than initially expected with states shutting down again, more REITs may seek accommodations in the coming months. Depending on the duration and evolution of the pandemic, it is likely that additional borrowers will need to adjust or waive financial covenants while other borrowers who have entered into financial covenant waiver periods may need to revisit their covenants in 2021 and get further relief and longer term extensions stretching into 2021 and 2022. While there will be additional challenges as REITs manage this crisis, the fact that many REITs came into the COVID-19 crisis with lower leverage levels and significant capital should continue to aid REIT borrowers as they work with their lenders on modifications to their credit facilities in order to manage their operations as they endure the impacts of this pandemic