There's an often overlooked aspect to acquisitions when it comes to the balance sheet: Buying an entire company means buying both its assets and the liabilities that come along with them.
When you look at Realty Income's (O -0.17%) $9.3 billion agreement to purchase Spirit Realty Capital (SRC), it also comes with $4.1 billion of debt. Here's why Realty Income couldn't be happier.
Rising interest rates are a problem for REITs
Real estate investment trusts (REITs) generally sell equity and issue debt to fund growth transactions. With rates heading higher of late, selling debt has become much more expensive. That makes it harder to justify property acquisitions.
Now add to this the fact that real estate markets tend to adjust slowly to interest rate changes, as sellers cling as long as they can to the prices they could demand when rates were lower. Often, property prices don't drop, improving returns and making deals attractive again despite higher interest rates, until there's financial stress for the seller (such as a mortgage coming due).
Image source: Getty Images.
That adjustment hasn't yet taken place, so REITs across the board are under pressure. Deals can be made, but they are harder to negotiate, take longer to close, and fewer desirable deals are available overall because sellers are still operating as if rates were near historical lows -- which they aren't.
That's one big reason why REIT shares have fallen dramatically, including those of both Realty Income and Spirit. Each was down by roughly a third from recent years' highs (before the deal was announced, anyway).
Given this backdrop, Realty Income jumped on the chance to buy Spirit, which is generally considered a well-run peer. It will make Realty Income an even bigger player than it already is in the net lease sector (net leases require tenants to pay most property-level operating costs).
Size comes with advantages, including the ability to take on bigger deals and a greater access to capital. Which brings the story to Spirit Realty's debt stack.
Realty Income isn't going to touch Spirit Realty's debt
When one company buys another one, it generally takes on the acquired company's debt obligations. That's exactly what is happening here. Realty Income will assume all of Spirit's $4.1 billion in debt. And Realty Income is quite happy to do it, too.
Overall, that $4.1 billion of debt has a maturity of 4.9 years and an average interest-rate cost of 3.48%. In other words, Realty Income is getting nearly five years' worth of debt that is below market cost. Some additional numbers will help show just how valuable this is.
According to Realty Income, Spirit has an unsecured term loan of $1.3 billion with another 2.9 years to run on it and an associated interest rate of 3.98%. If that term loan were to be priced today, the interest rate would be 6.31%, or 233 basis points higher. That's a huge difference.
The other big piece of Spirit's debt stack is a $2.75 billion unsecured note with a term of 5.9 years and an interest rate cost of 3.25%. If this loan were to be priced today, that interest rate would likely jump to 6.6%, or 335 basis points higher. Again, a massive increase.
Step back and consider the percentage changes here. An increase of 233 basis points (or 2.3 percentage points) from 3.98% is a nearly 60% increase. The added 335 basis points (or 3.35 percentage points) on top of 3.25% is a more than 100% increase!
No wonder Realty Income is happy to just keep paying the interest on the debt that will come along with Spirit. All of that debt, issued in years past, is at bargain rates compared to what it would cost to issue the same debt today.
Eventually, Spirit's debt will come due
While Realty Income is glad about this deal, the truth is that all of Spirit Realty's debt will eventually mature. When it does, Realty Income will have to either pay it off or, far more likely, issue new debt at higher rates.
But until that day comes, Realty Income is going to happily keep paying those below-market interest rates. The debt story is, perhaps, a hidden gem in the REIT's acquisition plan here.
