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As a quick follow-up to "Reggie Middleton on the Recent Ackman Short - Realty Income "O"", I took a look at the likelihood of O tripping their covenants in an attempt to keep the dividend intact.

Regarding Realty Income’s debt covenants - there is a bank owned credit facility of $355 million but as of July 21, 2009, the Company had no outstanding balance under it. Since, per the cash flow analysis linked above, it was observed that the Company will not face serious liquidity pressures in the next year unless the rental income declines severely (we assumed 5% consecutive decline for the next two fiscal halfs), the Company may not need to utilize the credit facility.

However, the Company is required to fulfill the debt covenants of the senior unsecured notes of $ 1,350 million. The table below summarizes the requirements under the debt covenants and the Company’s actual position as of June 20, 2009

Note Covenants

Actual

 

 

Debt to total adjusted assets should be less than 60%

38.7%

Secured debt to total adjusted assets should be less than 40%

0.0%

Debt service coverage ratio should be greater than 1.5x

3.5x

Total unencumbered assets to total unsecured debt should be more than 150%

258.0%

 Now, contrast this to the situation in the company below...

American Campus Communities Research Note

As highlighted in the 2Q09 results preview, ACC is expected to face a shortage (after considering operating cash flows, capex, debt repayments and dividend distribution) of $146 mn, $83 mn and $239 mn in 2H09, 2010 and 2011, respectively. (Detailed assumptions are enclosed in ACC 2Q-09 results preview: ACC 2Q09 results review 2009-08-12 01:25:50 110.50 Kb).  Although the company has a few alternatives with which to pull itself out of a GGP-like solvency spiral (see GGP and the type of investigative analysis you will not get from your brokerage house), we believe that all practically available options will be earnings-dilutive in some way or the other.  

FFO Growth

 

2.5%

2.5%

2.5%

2.5%

$ mn

2H-09

2010

2011

2012

2013

FFO

38

76

78

80

82

Recurring Capex

-5

-10

-10

-10

-10

New Development Capex

-9

 

-46

 

 

Dividend

-32

-65

-65

-65

-65

Debt Payable

-138

-84

-197

-75

-118

Total Outflow

-184

-159

-318

-150

-193

 

       

 

Shortfall

-146

-83

-240

-70

-111

Dividend cut: Although, on its face, a dividend cut seems like the easiest way out, it would not be sufficient to make up for the entire shortfall. In addition a cut in dividend could endanger the company's REIT status and harm investor sentiment. There is the possibility of an all stock dividend announcement, but eventually even the slowest of investors will wise up to this game of dilution in the face of lessening cash flows. What cash dividend investors want more stock of a company as a dividend when said company couldn't pay its cash dividend in the first place? Unfortunately, the answer to this question could be alarming.

Additional borrowing under the existing  revolving credit facility:  During August 2009 and September 2009, ACC closed on a Revolving Credit Facility which would increase total facilities by $65 mn and $125 mn, respectively.  We believe that additional borrowing under revolving credit facilities would be the most likely scenario for ACC. However, increase in short-term borrowings could result in asset liability mismatch and result in higher interest expense for the company.  Moreover, borrowings under revolving credit facility are short term in nature and would only postpone the problems till 2011, given the expected meager cash flows in the near-to-medium term.

Refinancing with long term debt / issue of new capital : We believe that the only way ACC could avoid shortfall problems is through issue of new capital and /or assumption of additional debt. Capital markets are (in our opinion) too far away from recovery to raise additional financing on amenable terms, and even if the company manages to raise finance through this option, it would lead to dilution of existing shareholders' earnings. Issue of long debt for REIT looks highly unlikely considering dearth of demand for CMBS.

We believe that the company, apart from short term borrowing through credit facilities, will make up for the shortfall by curtailing their new development capex and through sale of few of their existing properties at distressed prices that would put pressure on earnings. It has been quite some time since the company first started marketing its properties in an effort to raise capital, and to our knowledge, they have yet to find a taker. This is a testimony to the extremely soft commercial and residential real property markets.