Structured Finance

December 21, 2005

www.fitchratings.com

REITs/U.S. and Canada Special Report

TRuPS in REITS A Primer

Analysts Matthew D. Gallino +1 212 908-0218 matthew.gallino@fitchratings.com Tara S. Innes +1 212 908-0361 tara.innes@fitchratings.com

Summary Trust preferred securities (TRuPS) have become increasingly commonplace in the real estate investment trust (REIT) universe in 2005. This has resulted in many questions concerning Fitch’s view of how this affects the REIT market. “TRuPS in REITS (A Primer)” attempts to summarize and address these questions.

Approximately 110 companies in the 180-company REIT universe are not publicly rated by any rating agency, and most of these have less than $1 billion of equity capital. These companies tend to have very limited access to the market for long-term, committed unsecured financing. However, in order to meet even modest growth targets, REITs must have access to unsecured capital. Essentially, for lenders to provide secured financing for portfolio growth, REITs need to have a certain amount of their own unsecured funds to provide the lender with a cushion in the event of asset devaluation or default. Without unsecured capital, a REIT’s ability to grow is largely limited to its ability to increase the leverage on its existing capital base.

REITs are especially reliant on capital access because their ability to retain earnings is limited or nonexistent, depending on the company’s specific business model. An ordinary C-Corp, absent operating losses and excessive distribution, can often retain sufficient earnings that it can reinvest. However, REITs, which are required to pay 90% of their taxable income to shareholders in the form of dividends, have no such luxury. This is compounded by the fact that REITs, like most C-Corps, tend to be reluctant to have secondary equity offerings due to dilution concerns.

Many unrated issuers could theoretically tap unsecured capital markets but generally only at a prohibitive cost from both an economic and operating flexibility standpoint. There are several reasons for this, but for many REITs that have accessed the TRuPS market, it is due to some combination of very limited operating histories, poor or inconsistent financial performance, high leverage or lack of unencumbered assets to make unsecured investors comfortable. Also, covenants associated with unsecured bank lines, bonds or term loans impose limitations or thresholds on key metrics, such as fixed-charge coverage, leverage and net worth. In turn, these limitations would likely be unpalatable to young or small companies looking to aggressively expand and make strategic acquisitions. In addition, the cost may be prohibitive for certain issuers, such as those in the residential mortgage market, where net interest margins are often less than 2% with secured financing.

In 2005, TRuPS, which have long been a staple for commercial banks and insurance companies, have arrived to help fill the vacuum of

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unsecured capital available to the unrated REIT marketplace as well as for some real estate operating companies (REOCs) and homebuilders. Rather than being offered on an individual basis, TRuPS are pooled and sold to investors in the format of a collateralized debt obligation (CDO). Each CDO has TRuPS from as many as 25 different issuers, reducing an end-investors exposure to the failure of a few of the underlying entities. Because the risk is perceived to be somewhat lower through pooling and diversity, the cost is also lower, making it more economical than bank debt for the issuer. For small issuers, it also avoids the expense and effort required to independently launch a preferred stock or unsecured bond program. It has also helped fill a void for investors seeking new investment opportunities in real estate but too risk-averse to invest in single unrated REITs.

Basics TRuPS are unsecured subordinated instruments that in most cases are subordinate to all forms of capital in a REIT’s capital structure, except common equity and most other forms of preferred equity. To date in the REIT universe, most issuances have had a 30-year legal maturity but are callable within five years by the issuer. Financial covenants governing the security have generally been nonexistent, although guarantees from the issuing organization’s parent company are often provided to guarantee repayment.

In certain cases, issuers of the securities have the right to defer (but not cancel) payments for up to 20 consecutive quarterly periods.

The result is a relatively flexible form of unsecured, subordinated capital that most issuers will apply toward portfolio growth. Proceeds from the trust preferred security issuance are generally used by most issuers to help fund the purchase of new portfolio investments. Capital raised from the offering often helps provide the company’s “down payment” when it seeks secured financing. For example, a repurchase agreement (repo) may provide a REIT with an advance rate of 95 cents per dollar of pledged collateral. In this example, proceeds from the TRuPS will be used to purchase the remaining five cents of collateral to provide the necessary cushion for the repo provider. Similarly, a mortgage lender may require an equity REIT to have a maximum 85% loan to value on a potential acquisition. Proceeds from the TRuPs provide REITs with this necessary equity capital.

The potential portfolio effect from this is significant. A residential mortgage REIT that issues $25 million of TRuPS may leverage this amount between 10 times (x) and, in a few cases, as high as 25x. This translates to a growth in portfolio investments by $250 million to $625 million. For residential issuers that have completed two $25 million issuances of

Issuing Organization

OP – Operating partnership. CDO – Collateralized debt obligation. REIT – Real estate investment trust. Source: Company reports.

Trust Preferred CDO(Investor)

Parent Company

(Generally, a Public REIT)

OP Subsidiary

(Contains Most of Organizations Assets and Liabilities)

Delaware Statutory Trust

(Trust Preferred Security Issuer)

Guarantee(from Parent,OP, or Both)

Proceeds

JuniorSubordinated

Note

ProceedsTrust PreferredSecurity

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TRuPS, the net portfolio growth supported could be more than $1 billion. For equity REITs purchasing a property on an 85% loan to value, a $25 million TRuPS issuance will provide the company with enough equity capital to permit the purchase of a $167 million property.

How It Works For most issuers, a Delaware Statutory Trust is created within the capital structure of the issuing company. This entity has no other assets or liabilities other than to facilitate the TRuPS issuance. The trust, which is 100% owned directly or indirectly by the parent company, issues the TRuPS to the CDO (or to a warehouse entity set up by the CDO originator, if the CDO is still in a ramp-up phase) and receives the proceeds from the offering. The trust then loans the proceeds from the TRuPS offering to the parent company or other operating subsidiary of the parent company, such as an operating partnership. This loan is generally in the form of a junior subordinated note, which pays interest to the trust that corresponds to the trust’s dividend obligations associated with the

TRuPS offering. On the company’s consolidated financials, this structure generally appears as a junior subordinated loan or note.

The TRuPS and the corresponding junior subordinated notes typically do not have any individual covenants, such as net worth, fixed-charge coverage or unencumbered asset tests, which are common features for REIT debt. In limited cases, REITs have the ability to defer up to 20 cumulative quarters of dividend payments. However, this has generally been limited to issuers with stronger relative credit quality. Nevertheless, for purposes of the note holders, such a deferral is treated as a default by the CDO structure and can result in changes to the cash flow waterfall for the CDO note holders.

Some trust preferred CDOs have applied broad-based covenant tests, wherein multiple issuers that fall below certain common net worth or fixed-charge coverage tests could result in changes in the cash flow waterfall. Still, these issues will not affect the

Example of Trust Preferred CDO Arrangement

CMBS – Commercial mortgage backed securities. CDO – Collateralized debt obligation. REIT – Real estate investment trust. Note: Example only. All tranches shown may not exist, and diagram shown is not proportionate. Source: Company reports.

REIT Issuer 1

REIT Issuer 2

REIT Issuer 3

REIT Issuer 4

Assorted CMBS

REIT Issuer 5…..

…REIT Issuer X

IG REIT Bonds

CDO Trust(DelawareStatutory

Trust)

Owns TrustPreferred Notes

And otherInvestments such

As CMBS andREIT Bonds

Issues CDO NotesTo Fund Asset

Origination

‘AAA’

‘AA’

‘A’

‘BB’

‘BBB’

Equity

TrustPreferredIssuance

Secondary MarketPurchases

Issuanceof Tranches

of CDONotes

Assets Liabilities and Equity

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specific issuer (although they may create challenges if the issuers try to return to the market).

In some casers, a guarantee is provided to the trust by the parent company or other operating subsidiary with respect to repayment of the TRuPS. Most REITs tend to have very few assets at the parent company level but own an operating partnership that houses most real estate assets. This is more commonly called an umbrella partnership REIT (UPREIT). The operating partnership often issues most of the REIT’s secured, through special-purpose vehicles (SPVs), and unsecured debt, and as a result, any debt obligations of other entities within the issuing organization will be structurally subordinated to obligations within the operating partnership. As a result, although the TRuPS issued by a trust may have the implied security of a parent company guarantee or even an operating partnership guarantee, this would still be structurally subordinate to obligations within these entities, which for most REITs would include substantially all of the liabilities.

Pros and Cons

Issuing Companies All other factors being equal, Fitch tends to view the issuance of TRuPS as a positive for most issuers. The TRuPS market has provided a source of relatively low-cost, long-term unsecured capital to small REITs that have traditionally not had meaningful or consistent access to these markets.

Many of the small and/or unrated residential and commercial mortgage REITs operating today are heavily reliant on short-term secured capital, such as reverse repo or warehouse agreements for their funding. These arrangements, while low-cost and plentiful in today’s highly liquid capital markets environment, tend to contain very short commitments and are often subject to margin calls. Because they are not committed, or not committed for long, they create substantial interest rate and funding maturity gaps with the much longer term nature of the REITs’ assets.

Similarly, unrated equity REITs are often reliant on the mortgage, commercial mortgage-backed securities (CMBS) and CDO markets. While these forms of capital are plentiful in a liquid capital markets environment, they tend to severely limit an issuer’s operating flexibility, have significant

constraints an issuer’s ability to reposition a property and come with onerous prepayment penalties, making an asset sale or transfer difficult and expensive.

As these issuers and the capital markets have evolved, increasingly creative securitization and structures have been implemented to provide matched funding. These include CMBS, residential mortgage-backed securities (RMBS) and CDO technology. Still, while these satisfy a REIT’s needs for long-term fixed funding, they do not eliminate the need for flexible unsecured capital.

Whether short- or long-term secured financing is used, mortgage and equity REITs require generally between 4%–35% of their own unsecured capital to purchase assets on a secured basis. However, as many residential and commercial mortgage REITs have limited operating histories and a substantial portion or all of their assets are encumbered, they tend to have zero access to the public or private unsecured debt markets, and their narrow operating margins, particularly on the residential side, tend to render the long-term senior unsecured debt markets economically unfeasible. Equity REITs without unencumbered assets tend to be in the same boat with respect to unsecured market access.

Nevertheless, in order to continue their growth, issuers need the ability to access unsecured capital in order to raise the minimum 4%–35% they require to obtain secured financing. As issuers have grown, most of their initial public offering (IPO) capital has been used to fund assets, and with very limited internal capital formation rates, they are required to look elsewhere to raise capital. Secondary stock offerings are a relatively unpopular choice, as mortgage REIT stocks have been under pressure due to rising interest rates and issuing additional stock would create dilution.

A solution to this dilemma for many issuers has been the TRuPS market. There is little downside to this market for most issuers. Because they are substantially all included in CDOs, individual issuers with credit issues or limited operating histories are often able to issue because the CDO investor takes comfort in the size and diversity of the much larger pool being invested.

Larger investment-grade issuers have also, in certain cases, accessed the TRuPS market due to its low cost and relatively efficient execution. Nevertheless, some larger issuers avoid this market because they already

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have access to solid execution on their existing debt and preferred stock programs. Also, the $25 million–$50 million slugs in which TRuPS have so far been offered are not large enough to make a dent in their capital requirements relative to the legal resources needed to execute the transaction. Certain issuers have circumvented this issue by issuing larger amounts, which have been divided into multiple CDOs.

As REITs continue to issue TRuPS, however, they will need to consider its effect on their existing or future preferred stock ratings. In most cases, TRuPS are junior to senior unsecured debt but senior to preferred stock. This increases the gap between an issuer’s ratio of total debt-to-undepreciated book capital and total debt plus preferred stock-to-undepreciated book capital. This metric plays a significant role in determining the notching between the senior and preferred ratings. A larger gap increases the likelihood that the notching will be higher.

Investors One of the most critical aspects of assessing a TRuPS is considering the issuing company’s legal structure. The key question to consider is, how close is the issuing trust to the assets? Most REITs that have issued TRuPS so far tend to have little to no unencumbered assets, which means that in a liquidation scenario, there would likely be little to no assets remaining for satisfaction of the subordinated unsecured obligation. In essence, other secured lenders already have a first lien or a pledge of the collateral.

Many structures attempt to use a parent guarantee to work around the subordination issues. Nevertheless, the guarantee is only as good as the entity that offers it. For most REITs, the parent-level organization has very few assets and is relying on the operating partnership or other subsidiaries for repayment.

In addition, most unsecured capital currently available to the REIT sector, even among investment-grade issuers, comes with covenants. By contrast, the

REIT TRuPS and their counterpart junior subordinated notes have no direct security-level financial covenants that would allow an investor to declare a default as a company’s financial condition deteriorated. However, in some cases, the collateral manager for the CDO transaction can declare a default in the event that a company’s assessment drops to ‘CC’ or below. Furthermore, many securities have a mechanism that allows deferral of payments for up to 20 quarters, particularly in the case of issuers with stronger credit quality.

In Fitch’s view, the real strength for investors is that TRuPS are packaged in CDOs. To date, transactions, such as Merrill Lynch & Co., Inc.’s Taberna Capital Management LLC transactions have had approximately 25 issuers, each totaling between $700 million–$1 billion in total assets. The size and relative diversity of the CDO transactions help offset the risk of default any one issuer will cause.

Treatment in Leverage Calculations For purposes of calculating leverage, TRuPS are treated as neither 100% debt nor 100% equity. Based on the structural characteristics of most recently issued TRuPS in the REIT universe, most will receive between 60%–69% equity credit. This means that for a $100 million issuance of TRuPS (which show up as junior subordinated notes on most REIT balance sheets), between $60 million–$69 million of the TRuPS will count as equity in the leverage calculation, while the remainder will be treated as debt.

Nevertheless, the overall equity credit range for TRuPS in general is 0%–69%. The determining factor as to exactly where in the 0%–69% range each company will come out depends on the length of time to maturity and the length of time that an issuer can defer interest and/or dividend payments. A full detailed discussion of this methodology can be found in the criteria report, “Hybrid Securities: Evaluating the Credit Impact — Revisited,” which can be found on Fitch’s Web site.

Summary of Trust Preferred Security Treatment Equity Credit Range (%) Security Type 60–69 Long-dated at issuance and deeply subordinated in standing; available deferral period of three years or

longer; weak financial covenants, if any. 0–49 Deferral period less than three years; financial covenants similar to senior debt.

Source: Fitch Ratings’ "Hybrid Securities: Evaluating the Impact – Revisited," available at www.fitchratings.com.

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Treatment of Interest or Dividends in Operating Performance

In general, Fitch will include the expense for either the junior subordinated notes or the TRuPS in both interest expense and fixed-coverage charge calculations. Although the dividends are often deferrable, they are also cumulative. Fitch believes that, for issuers that use it, this capital source is a direct contributor to the long-term sustainability of a REIT’s operating platform and, as a result, expects that it will be maintained through operating cycles on a timely basis.

Notching In Fitch’s formal rating process, TRuPS issuances will be notched off of the issuer default rating (IDR) of either the parent company or operating partnership, depending on the company’s business model and legal structure. It is anticipated that for most issuers with a below-investment-grade IDR, this would be two or three notches below the IDR.

Nevertheless, this is not a concrete rule, and the notching determination will heavily consider the statutory trust’s location in the company’s consolidated legal organization structure. The further removed it is from quality, liquid assets, the greater likelihood the notching will be larger. Specific attention is paid to the availability and liquidity of unencumbered assets and the cash flows generated by such assets.

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