By Christopher M. Wright

NAME: Steven Marks TITLE: Managing Director at Fitch Ratings BORN: 1969 EXPERIENCE: Marks joined Fitch Ratings in December 2006 after eight years in real estate investment banking at Bear Stearns & Co. Prior to that, he worked in the real estate audit group at KPMG. He holds an accounting degree from the University of Maryland and an MBA from the University of Virginia Darden Graduate School of Business.

As any credit analyst will tell you, the role of debt in the financial market is more important than ever. With this in mind, Fitch Ratings decided it needed someone to lead its analysis of the most complex REIT ratings and to create leading industry research. Since December 2006, Steven Marks, managing director, has become a key player in the REIT public debt arena.

Marks cut his teeth in real estate finance at KPMG and then moved to Bear Stearns & Co. where he refined his understanding of REIT valuations, advised on REIT M&A transactions and underwrote $5.5 billion worth of real estate securities offerings.

Portfolio sat down with Marks to discuss his thoughts on REIT industry leverage levels and recent actions regarding bondholder covenants.

Portfolio: What is your ratings outlook for the REIT industry for the next two years?
Marks: Our view on the sector was positive in our February 2007 "REIT Scorecard," given strong real estate fundamentals, particularly in multifamily, office and lodging.

However, now our view is leaning more toward a stable outlook because the supply pipeline is increasing, leverage metrics have gone up slightly and same-store net operating income (NOI) growth is slowing. Additionally, there's been some loosening in covenant protections for unsecured bondholders.

Portfolio: Going forward, what are the biggest threats to REIT ratings?
Marks: Looking at the asset side, it would be further weakening in same-store NOI growth. Speculative development could become a concern. We're not seeing a threat to any large degree now, but most REITs with a development platform have projects that are not 100 percent pre-leased.

On the financing side, the biggest threats would be a significant increase in secured indebtedness and unfriendly actions to bondholders such as buying back common stock with debt. However, we believe these will come to pass.

Portfolio: Is there a particular REIT sector that concerns you more than others?
Marks: Lodging raises some concerns, because of the lack of predictability of revenue. Lodging tenants check out every day and operations have high fixed costs.

The lodging sector also worries us because of volatility. There's always the potential for geopolitical events to affect the travel and leisure industry. There's nothing actively worrying us at the moment, but that geopolitical risk is always there.

Portfolio: How do you view the REIT industry's ability to maintain debt ratings through the next economic downturn?
Marks: The empirical evidence illustrates that real estate is a more stable asset class than most, so REIT ratings are more likely to be resilient, presuming the companies are well-managed. The REIT industry went through a downturn from 2001 to 2004 and there were very few downgrades.

Given the underlying stability of the assets, we would expect another economic downturn would affect REITs less than other industries, but that's not to say that there would be no effect. Real estate is only as valuable as the businesses that use it, so if the overall economy suffers a downturn, real estate values should decline as well.

Portfolio: It's commonly observed by credit analysts that REITs are limited in the amount of cash they may retain. Is this a big issue for debt ratings?
Marks: It can be for certain REITs. As I mentioned, we like to see issuers having a certain amount of equity. We add 10 percent to 15 percent in our REIT capital standards metrics beyond what we require for a non-REIT to reflect the fact that REITs may pay out taxable income as dividends, or therefore find it more difficult to grow organically through capital formation. Thus, many REITs need to access the markets for growth capital from time to time.

Portfolio: Debt covenants refer to constraints on pledging assets or the amount of debt that can be added after the unsecured bond issue. How does this concern you?
Marks: If REITs were to add leverage without financial covenants, REIT unsecured bondholders would be at a disadvantage. There's a risk they could become deeply subordinated to a lot of senior secured debt.

In traditional REIT bond covenants, there's a limit to how much secured debt a REIT can have.

Portfolio: How has REIT leverage been affected by increased merger and acquisition activity from the last two years?
Marks: Increased leverage levels are a response to M&A. Low cost debt financing has made private buyers more competitive on the acquisition front. One way for public REITs to compete with private investors is by utilizing more leverage.

This has affected REIT ratings, not across the board, but there are examples where we have changed our outlook or rating on companies that have increased leverage for this purpose.

For example, Fitch changed the Issuer Default Rating for Equity Residential (NYSE: EQR) from 'A' to 'A-' in May 2007; for Duke Realty Corporation (NYSE: DRE), Fitch changed the outlook to Negative in April 2007.

Portfolio: In 2004, Fitch said that REIT joint ventures caused earnings volatility, acting as a drag on core portfolio performance, and saddling unsecured lenders with financing risk. In 2006, the company commented favorably on REIT joint ventures, saying the opportunities are different from those on the balance sheet, and the utilization of private capital is a positive. What is the company thinking now?
Marks: There are positives and negatives. We view joint ventures net positively. They increase the risk of adverse selection, putting higher quality assets into a joint venture and leaving unsecured bondholders with less favorable assets on the balance sheet. Joint ventures also have the potential to distract management now that the REIT has a large institutional partner relationship to manage.

On the positive side, joint ventures validate REIT managements and the REIT platform. Institutional capital is willing to invest and that's a vote of confidence that REITs have created sustainable businesses.

Portfolio: Qualitatively, what can REITs do to improve their credit ratings?
Marks: Qualitative factors we like to see are portfolio diversification—by tenant, geography, lease expiration dates—and demonstrated access to capital.

Portfolio: Some REIT CEOs recently expressed concern that capital for real estate will not always be as plentiful as it is today. If capital were to dry up, how would that affect REIT credit ratings?
Marks: It depends on what capital REITs could still access at that point. If the unsecured bond market were to dry up and REITs had more difficulty refinancing maturing debt or renewing unsecured lines of credit, that would affect ratings more than not being able to access the stock market for new equity.

Portfolio: Do you view U.S. REITs expanding internationally as a positive or negative and why?
Marks: REIT international diversification is a net positive. We're in a challenging environment for U.S. property acquisitions, so it makes sense that REITs are looking for sources of incremental revenue growth internationally. There are risks, such as political risks, different tax regimes and currency exposure that need to be considered.

International expansion also can put a strain on management's time. The right way to mitigate some of the risk is to establish partnerships with local developers and real estate companies that understand the local laws and customs and how to do business in a specific market.

Portfolio: Is there anything new at Fitch in terms of the way you assess REIT creditworthiness?
Marks: Yes, we recently finalized a methodology we call 'REIT Risk-Adjusted Earnings' where we give a haircut to REIT revenue streams that are not part of core sustainable cash flow. We plug the new number into a variety of metrics such as fixed charge coverage.

We created another metric called "REIT Capital Standards," where we look at a REIT's capital structure and determine the appropriate amount of equity we think a REIT should have. Mathematically, REITs can boost return on equity simply by raising debt. More of an equity cushion is always better for unsecured bondholders.