Rating Methodology for J-REIT

Transcription

1 Rating Methodology for J-REIT Rating and Investment Information, Inc. (R&I) has updated its Rating Methodology for J-REIT. 1/7 July 21, 2016 I. Basic J-REIT Characteristics J-REITs, which are established under the Act on Investment Trusts and Investment Corporations (Investment Trust Act), are investment corporations (toushi-houjin) that primarily invest in and manage real estate. Under so-called external management structures, J-REITs themselves cannot hire employees and conduct substantive activities, and by law their actual management activities are consigned to an outside asset management company. Through the organs of a board of directors and general meeting of unitholders, J-REITs are responsible for the function of monitoring asset management activities. Compared with real estate companies and other alternatives, the following can be highlighted as J-REIT characteristics. (1) De facto specialization in the real estate leasing business If properties are already leased and possess decent competitive strengths, the real estate leasing business is a comparatively low-risk business that is capable of generating stable, long-term cash flows. Many real estate companies are engaged in property development or brokerage activities that are susceptible to the effects of market conditions, in addition to their property leasing business, and even in businesses other than real estate. Because J-REITs are de facto specialized in the leasing business, their business risks are diminished. (2) High transparency In addition to the information disclosure required by the various provisions of the Investment Trust Act, the Financial Instruments and Exchange Act, the Tokyo Stock Exchange Listing Regulations and the Rules of the Investment Trusts Association, Japan, in many cases J-REITs release information concerning their portfolio (e.g. sellers of new investment properties, acquisition prices, appraisal values, property revenues and expenditures) and financial conditions (e.g. lenders, maturities, interest rates) at a level that is more detailed than required by regulations. J-REITs therefore have high transparency compared with ordinary companies. (3) Ample equity capital and comparatively strict financial discipline Many J-REITs disclose their target loan-to-value ratio (LTV) during normal periods, and the actual LTV is basically maintained within a range of 55% or less. This is a comparatively conservative level that corresponds to an equity ratio of 40% or higher. While compliance with the target level is not compulsory, it is one type of commitment the management team has made with the market in mind, and can be considered to possess a commensurate degree of binding force. Even if a J-REIT deviates from its target level, the upper limit on the LTV established by the J-REIT s loan covenants will act as a brake. Characteristics (1) and (2) above can be thought to essentially decrease business risk, while (3) basically serves to reduce financial risk, and all three operate positively on a J-REIT s rating. One negative characteristic, on the other hand, is the fact retained earnings are limited and debt repayment depends primarily on refinancing, making J-REITs quite susceptible to the trend in the financing environment. (The extent to which this is a negative point varies greatly depending on the financial condition of each J-REIT.) < Considerations with regard to sponsors > Because of J-REITs' external management structures, when assigning a rating R&I evaluates the management capabilities of the asset management firm that performs the actual investment activities, as well as the status of the investment portfolio and the REIT s financial condition. To evaluate the management skills of the asset management company, R&I will also include as part of its rating evaluation an assessment of the business base, track records and support circumstances of the sponsor, who is the asset manager's parent company or shareholder.

2 Furthermore, based on the fact financial institutions still have a strong tendency to emphasize a sponsor s creditworthiness when deciding whether to finance a REIT, for its ratings R&I takes into consideration the sponsor s creditworthiness as well. During the financial crisis in the second half of 2008, refinance risk was actualized at REITs where the sponsor s creditworthiness was weak. REITs that had engaged in reliable financing based on the strong sponsor creditworthiness, however, encountered no major refinancing problems. II. Evaluation of Business Risk Because J-REITs are corporations that manage real estate leasing businesses, they are exposed to the risk of a decline in the asset value or cash flow of their property holdings. There also is a risk the quality of the portfolio will deteriorate if the asset management company does not engage in appropriate management (new investment and property management). To evaluate the former risk, R&I analyzes (1) the quality and stability of the properties held and (2) portfolio diversification, while for the latter risk it examines (3) external growth and (4) internal growth. R&I also confirms (5) whether sufficient measures to prevent conflicts of interest with the sponsor have been put into place. (1) Quality and stability of properties held The properties held are the sources of a REIT s value and cash flow, and thus are an extremely important factor for assessing business risk. R&I will evaluate the competitiveness of individual properties, and the stability of each property s cash flow, mainly by studying the parameters enumerated below. These parameters are nearly identical to those typically studied when investors and lenders evaluate real estate. i. Regions: R&I investigates the strength of demand in the regions where a REIT's properties are located and factors such as the dominance of the property locations within the regions. If many of the properties are located in areas where demand is strong, with relatively excellent locations within the regions, R&I can evaluate the properties to be capable of generating steady cash flow over the medium to long-term and maintaining their value. ii. Uses: R&I evaluates factors such as substitutability of tenants, the liquidity of the property market, and property management risks, considering the use of the properties a REIT invests in. In general, attracting follow-up tenants or disposing of a property will be comparatively easy if assets are in large-scale rental or property markets, such as office buildings or residential properties. On the other hand, the number of tenant candidates for properties such as hotels or suburban retail facilities is limited, and the liquidity of these properties is relatively low. Nevertheless, for these uses as well, if the properties are highly competitive as shops and are managed by a strong property management firm, and rents are set in a range that makes it possible to cover the expense burden from earnings generated from the shops, R&I can judge the investment risk to be mitigated. iii. Property sizes: As the number of large-scale properties is limited, they generally are considered to be more competitive than smaller properties. Certainly there also are instances where properties such as small-scale office buildings in front of a railway station with strong demand from store tenants, or neighborhood-oriented retail facilities with strong local ties, are highly competitive even though small or medium-sized, and such properties must be evaluated on a case-by-case basis. iv. Years since construction (specifications of facilities): Because recently completed properties are considered to be superior in attracting tenants and be equipped with facilities of comparatively high quality, R&I investigates factors such as the distribution of portfolio properties by number of years since construction, or the average number of years since construction of the portfolio. If properties have been renovated appropriately, however, the properties may be able to maintain their competitiveness regardless of the number of years since construction. 2/7

3 v. Type of ownership: If properties are held under any other rights than fee simple, such as comparted ownership, co-ownership, or by way of ground leasehold, the liquidity of property transactions will normally decrease and freedom of control will be restricted. Therefore it is preferable for the percentage of properties that are not fee simple to be low, and when the principal properties include properties with comparted ownership or co-ownership, R&I will scrutinize the degree of risk based on factors such as the ownership percentage, the agreement among owners, and the creditworthiness of the other owners. vi. Earthquake proofing: R&I judges the degree of earthquake risk based on factors such as the Probable Maximum Losses (PML) for the individual properties, or the portfolio PML taking into consideration regional diversification. vii. Occupancy rates: R&I verifies the current occupancy circumstances and past changes in occupancy for each property. If the number of tenants is small, however, it is easier for a REIT to maintain a high occupancy rate, and the evaluation must be made in conjunction with a review of tenant diversification. (2) Portfolio diversification As a general rule, the greater the effectiveness of portfolio diversification, the more it is possible to mitigate the size of any decline in overall asset value or cash flow. While there are several types of diversification as described below, for ratings R&I emphasizes property diversification in i. and tenant diversification in ii. Another evaluation point in addition to portfolio diversification is the size of total assets, which is believed to bestow numerous advantages including greater management efficiency, a smaller range of fluctuation in leverage and improved investment unit liquidity. i. Property diversification: R&I looks mainly at the degree of concentration for the leading properties. When a high degree of concentration is found, R&I looks at the competitiveness of the properties in detail. Needless to say, however, the quality and stability of the properties is of primary importance, because diversification of the properties is not meaningful if the competitiveness of the properties is low. ii. Tenant diversification: When there is concentration towards large tenants, R&I analyzes the creditworthiness of the key tenants and the possibility of such tenants vacating the property (details of the leases and importance of said property for the tenants). Investments that rely entirely on the creditworthiness of current tenants are viewed as risky, however. R&I will thus investigate factors such as the possibility of substitute tenants renting space in the property, the earnings level that can be assumed in such a situation, and the need for additional investment accompanying a tenant substitution. iii. Regional diversification: When properties are concentrated in a specific region, the risk of a change in cash flow will increase because the REIT is more easily affected by the market trend in that region. In the case of Japan, however, the scale of the economy in the Tokyo metropolitan area dwarfs that of any other region, and therefore R&I does not regard, in principle, the concentration of properties in the Tokyo metropolitan area as a cause for concern. In addition, the fact the benefits of regional diversification will vary depending on use should be noted. For office buildings, for example, given a situation where head office functions are concentrated in Tokyo, diversified investment in local areas will be restricted to some degree. Meanwhile, retail facilities can be established comparatively widely in locations boasting strong market areas, and even if the investment percentage in regional cities is high, this alone cannot be deemed reason to arrive at a negative evaluation. iv. Use diversification: Diversification of property use is considered to contribute to portfolio stability because the factors affecting asset value and cash flow tend to differ depending upon property use. 3/7

4 On the other hand, to the extent property use is diversified, property management can be anticipated to be more difficult because investment decision points or management procedures will vary greatly according to each use. Therefore R&I does not judge indiscriminate diversification of properties by use to be advantageous in and of itself. (3) External growth (investment) Because a rating fundamentally assumes the characteristics of the current portfolio will not change greatly in the future, REITs should disclose their investment criteria as clearly as possible. The more specific the investment criteria, the better the future prospects of the portfolio. Because frequently the investment criteria disclosed to the public are written somewhat abstractly in order to not hinder flexible investment decisions, R&I will evaluate the external growth policy through means such as interviews with the asset management company and analysis of the investment results achieved to-date. In addition, it is important that REITs make investments on the assumption of long-term property ownership. Certainly, reviewing the portfolio through the external growth process and selling properties with the intent of improving the portfolio quality is desirable. When a REIT has declared from the beginning a policy of seeking capital gains through short-term property turnover, however, R&I must consider the fact operating results will be affected more easily by real estate price fluctuations. A REIT that boasts an excellent information network and strong property sourcing capabilities can improve its portfolio quality or achieve diversification by acquiring numerous high-quality properties. The probability it can acquire properties under reasonable conditions through bilateral transactions, without becoming involved in excessive competition such as public auctions, increases as well. Conversely, if a REIT lacks strong sourcing capabilities, the danger of the REIT not adequately diversifying its portfolio, purchasing properties at unduly high prices or acquiring inferior quality properties increases. An overly aggressive growth policy will increase the danger of deterioration in portfolio quality, as well as the possibility growth will have a negative effect on a REIT s financial position. In fact, REITs that made large investments during the period around 2007 when real estate values soared and purchased properties at the price peak saw unrealized losses on their properties expand, and profitability decline. Because they raised property acquisition capital with debt, their financial conditions deteriorated as well. While accurately ascertaining the real estate price cycle is never easy, a REIT must have a prudent investment stance to avoid unreasonable acquisitions as much as possible. The sponsor will have an important influence on external growth through means such as supplying human resources and know-how to the asset management company or by providing property, agency servicing, and information. In fact, the property sourcing capacity of REITs in particular relies heavily on the sponsor s support. Therefore the sponsor s business development capabilities in the real estate sector and the strength of cooperation between the sponsor and the REIT must be adequately considered. (4) Internal growth (management) Managing properties efficiently, attracting tenants with favorable terms and carrying out renovation work when necessary are indispensable for maintaining and improving property values. Therefore, creating circumstances in which a REIT will manage the properties efficiently and effectively while cooperating closely with the property management company is necessary. Systematizing management in preparation for growth in the number of properties and number of tenants also is considered an effective approach. When a REIT holds properties for which facilities management is assumed to be comparatively difficult, such as retail facilities and hotels, a high level of knowledge and experience is needed in order to maintain their competitiveness. Even if the REIT has consigned management to a prominent property 4/7

5 manager, the probability the earning capacity of the properties will be affected if the property manager is replaced must be assumed. The sponsor s presence will have a substantial effect on internal growth as well. For tenant leasing in particular, being able to use the functions of the sponsor group frequently is a strong point. For this reason the sponsor s business development capabilities in the real estate sector and the strength of cooperation between the sponsor and the REIT must be adequately considered. (5) Measures to prevent conflicts of interest with the sponsor A sponsor will have many instances for dealing with a REIT during the REIT's various phases, including property purchases and sales or brokerage, the provision of information, tenant brokerage and receipt of consignment of property management activities. Consideration must be given to conflicts of interest at such times. These include selling the sponsor's inferior quality properties to the REIT at high prices, and placing priority on attracting tenants to the properties owned by the sponsor. The possibility of the sponsor blindly expanding the size of assets to increase asset management fees also cannot be ignored. On these points, R&I will confirm whether the conflict of interest risk is mitigated by examining factors such as the content of the REIT's own rules for preventing conflict of interest, the aggressiveness of information disclosure, the asset management company's shareholder structure, the sponsor's investment percentage in the REIT, and the structure of the asset management fees. Additionally, R&I will confirm the appropriateness of the acquisition prices for properties purchased from the sponsor. III. Evaluation of Financial Risk In order to qualify for tax exemption, J-REITs are required to distribute over 90% of available earnings as dividends. It is therefore difficult for them to retain earnings and accumulate capital. On the other hand, because the LTV will increase through the process of acquiring properties with borrowed funds, managing a REIT by increasing capital at the appropriate time, reinforcing equity capital and lowering the LTV is extremely important. A J-REIT also must build a strong funding base that can withstand a rise in interest rates or deterioration of the finance environment while continuing to ensure appropriate cash flow corresponding to the risk of the portfolio. Based on its recognition of the above considerations, R&I analyzes and evaluates the four rating factors described below. (1) Leverage control: LTV calculated using several methods (LTV on a book value basis, LTV on a market price basis, LTV including security deposits) The LTV is one of the most important indicators for evaluating the soundness of a REIT s financial profile. In many cases, the LTV is set as a management benchmark during a normal period, and during interviews conducted with the asset management company management team and staff, R&I will confirm the policy concerning leverage. While reducing LTV through a capital increase will improve the creditworthiness of the debt, there is a potential this will result in dilution or a decrease in dividends for the equity investors. Depending on the circumstances, there also is a possibility the interests of the debt investors and the equity investors will be at odds with regard to the LTV level. Accordingly, this demands a strong intent on the part of the management team to maintain sound finances and not opt for easy unit price maintenance measures. When R&I judges such intent is not strong in light of its interview findings and past operating results, R&I will assume a more conservative LTV level forecast. 5/7

6 For its LTV evaluations, R&I utilizes indicators calculated using several methods. The three ratios mainly used are the LTV on a book value basis, the LTV on a market price basis and the LTV including security deposits. By examining multiple indicators, R&I is able to make evaluations of leverage that better approximate reality with differences in unrealized gains and losses and the level of security deposits taken into account. Another critical point is the feasibility of continuous capital increases. Compared with operating companies, a REIT must complete frequent, continuous capital increases in order to maintain the LTV within the target range while achieving external growth. Consequently R&I evaluates the ease of access to the investment unit market based on, among others, the results of capital increases, the investment unit price, the market capitalization and the relative performance of these factors. (2) Cash flow level (profitability): NOI yield, interest coverage ratio and EPS To manage a REIT stably over the medium to long-term, it is critical to keep investors satisfied by distributing sufficient dividends while covering expenses and interest payments. This means the management team must ensure a level of cash flow (profitability) that is commensurate with or exceed the quality of assets. For judging profitability, R&I focuses on indicators such as NOI (net operating income) yield, the interest coverage ratio (EBITDA/cost of debt) and EPS (earnings per investment unit; on a pre-split basis). (3) Debt duration: Average remaining term to maturity Because REITs invest in real estate over the long term, the preferred approach is to mitigate the risk from rising interest rates by borrowing funds at long-term, fixed interest rates tailored to the assets and matching the duration on the asset and liability sides of the balance sheet. Extending the duration is also important in the sense that it reduces refinance risk. (4) Liquidity risk (refinance risk) The J-REIT market turmoil that originated in the financial crisis in 2008 threw into sharp relief the weakness of REITs that depended on refinancing as a source of funding for the repayment of debt. Several examples were noted of REITs that encountered difficulties in smoothly completing refinancing when the creditworthiness of sponsors including new real estate companies plunged rapidly, even though the REITs own cash flow was steady and the REITs had provided collateral with asset values that will sufficiently cover the debt. This highlighted yet again the fact that refinance risk management is vitally important. In addition to the management of leverage, measures such as strengthening the business relationship with financial institutions, lengthening debt maturities, diversifying repayment dates and ensuring liquidity (e.g. cash, deposits and committed lines of credit) can be enumerated as specific details of management. With regard to the business relationship with financial institutions, so-called bank formation is important; it is desirable to have a balanced debt structure built around an established main bank, in which major domestic financial institutions including megabanks and trust banks each have a large share and there is no extreme bias toward any specific financial institution. For REITs with a high rating, the ability to obtain unsecured loans also is imperative. The reason is that the very ability to borrow without providing collateral is considered to demonstrate the level of trust from the transaction banks and also enables a REIT to flexibly execute property sales and new borrowing without being restricted by loan covenants. Moreover, when a loan is secured, unsecured bonds become substantively subordinated, making bond issuance difficult. 6/7

7 When evaluating a REIT s refinance risk, R&I will also focus on the creditworthiness and attributes of the sponsor, reflecting the fact that financial institutions place emphasis on the creditworthiness of the REIT s sponsor when considering whether to provide financing to the REIT. IV. Rating for J-REIT Issuer Rating Business Risk Financial Risk Importance Importance Indicator Quality and stability of properties held Leverage control LTV on a book value basis Portfolio diversification LTV on a market price basis External growth (investment) LTV including security deposits Internal growth (management) (Feasibility of continuous capital increases) Measures to prevent conflicts of interest with the sponsor Cash flow level (profitability) NOI yield Interest coverage ratio EPS (on a pre-split basis) Debt duration Average remaining term to maturity Liquidity risk (Refinance risk) Basic J-REIT Characteristics Note) Importance is indicated by : extremely important, : important, or relatively important. * This report replaces all previous versions that have been released to date. The Rating Determination Policy and the Rating Methodologies R&I uses in connection with evaluation of creditworthiness (collectively, the "Rating Determination Policy and Methodologies") are R&I's opinions prepared based on R&I's own analysis and research, and R&I makes no representation or warranty, express or implied, as to the accuracy, timeliness, adequacy, completeness, merchantability, fitness for any particular purpose, or any other matter with respect to the Rating Determination Policy and Methodologies. Further, disclosure of the Rating Determination Policy and Methodologies by R&I does not constitute any form of advice regarding investment decisions or financial matters or comment on the suitability of any investment for any party. R&I is not liable in any way for any damage arising in respect of a user or other third party in relation to the content or the use of the Rating Determination Policy and Methodologies, regardless of the reason for the claim, and irrespective of negligence or fault of R&I. All rights and interests (including patent rights, copyrights, other intellectual property rights, and know-how) regarding the Rating Determination Policy and Methodologies belong to R&I. Use of the Rating Determination Policy and Methodologies, in whole or in part, for purposes beyond personal use (including reproducing, amending, sending, distributing, transferring, lending, translating, or adapting the information), and storing the Rating Determination Policy and Methodologies for subsequent use, is prohibited without R&I's prior written permission. Japanese is the official language of this material and if there are any inconsistencies or discrepancies between the information written in Japanese and the information written in languages other than Japanese the information written in Japanese will take precedence. Rating and Investment Information, Inc. Nihonbashi 1-chome Mitsui Bldg., 1-4-1, Nihonbashi, Chuo-ku, Tokyo , Japan Investors Service Department TEL FAX infodept@r-i.co.jp 7/7