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Ask Millionacres -- Should I Be Worried When My REITs Take on More Debt?

Jul 09, 2020 by Matt Frankel, CFP
Q: I just saw that Realty Income (NYSE: O) had filed for more long-term debt ($600 million in 3.25% notes due 2031). I'm still learning about REITs, but should this be a concern for shareholders? To my understanding they were positioned well, and they said the purpose for this additional capital was to pay borrowings, fund potential investments, and general purpose. I don't fully understand a REIT's balance sheet enough to see if this taking on debt is a good thing or if they could've done another route, like temporarily suspend a dividend. -- James

A: The short answer is that a real estate investment trust, or REIT, taking on debt can certainly be a good thing, but it depends on why the company chose to add to its debt load.

As you mentioned, Realty Income is using its recently issued debt for repayment of existing debt, funding investments, and general corporate purposes. So let's look at these one at a time.

We'll start with repayment of debt. When REITs borrow money, it works a little differently than the mortgage you use to buy a house. Specifically, the company typically pays the interest only, and the principal is due as a lump sum at the maturity date. In other words, Realty Income will pay 3.25% interest on its $600 million in debt ($19.5 million per year) until 2031, at which point it will be required to repay the $600 million.

A look at the current debt structure shows that Realty Income has $333 million of its debt coming due this year and another $69 million due in 2021. Repaying this debt can certainly be a valid reason for issuing new debt.

This is especially true when interest rates are low like they are right now. Think of this in terms of refinancing a mortgage. If a company originally borrowed money at 5% interest and can issue new debt at 3% interest, using new debt to pay the old can result in significant savings.

Next, REITs often issue debt to help fund acquisitions, which can be an excellent way to boost shareholder returns. This is a simplified example, but if you can borrow money at 3.25% interest and buy properties that generate 6% annual returns, the math works out in shareholders' favor. Most REITs use some level of debt to fund acquisitions just like most homebuyers use a mortgage.

Finally, issuing debt for "general corporate purposes" can be a gray area, simply because this can mean almost anything. And typically you don't want to see debt being issued only for general corporate purposes. But as long as the primary reasons for issuing debt are the other two, shareholders generally shouldn't be alarmed -- especially when the debt is being issued by a company with A-rated credit like Realty Income.

You also mentioned suspending the dividend as an alternative to using debt. This can be a good alternative to debt if the company isn't earning enough money to cover its payout. We've seen this in several mall and hotel REITs, for example.

Having said that, Realty Income pays out about $2.80 per year in dividends and generated $3.32 per share in funds from operations in 2019. The COVID-19 pandemic will likely have a mild effect on profitability, but there's no reason to believe that the debt being issued is going to be used to pay the dividend.

To sum it up, debt is a normal part of running a real estate investment trust, just as it's a normal part of buying investment properties. And just like when debt is used to purchase investment properties, when it's used responsibly, it can be a good thing. Debt issuance should certainly be evaluated on a case-by-case basis, but in general, when a rock-solid REIT like Realty Income issues debt, it's a normal part of the business and not a cause for alarm.

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Matthew Frankel, CFP owns shares of Realty Income. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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