2 Stocks I Would Actively Avoid This Week – The Motley Fool | Vette Leader

Debt is the lifeblood of real estate investing, particularly Real Estate Investment Trusts (REITs). REITs must pay out most of their net income in the form of dividends, so they can only fund new purchases with debt or by issuing new shares. More often than not, they choose to go into debt. It works well when times are good, and REITs can grow quickly and still pay reliable dividends. But what happens when the market turns?

The dividend payout rule means that REITs rarely pay off debt in full without offloading real estate. Cash flow is distributed to shareholders or used as a down payment on new properties, and debt is eventually refinanced and pushed further into the future. With interest rates rising and earnings potentially falling, highly leveraged REITs could struggle to refinance and maintain the same margins going forward.

Let’s take a look at two REITs, Additional storage space (EXR 0.86%) and Boston properties (BXP -1.19%)who have heavy debt burdens and may struggle to navigate the new normal for years to come.

1. Extra space

Extra Space has been one of two big dogs in the self-storage industry over the past decade. It has used debt to buy up mom-and-pop self-storage stores and used its economies of scale and centralized management to make operations far more efficient.

It is undeniable that it worked well. Revenue has grown from $520 million in 2013 to $1.76 billion today. The stock has posted a total return of 918% over the past 10 years. The dividend has nearly doubled over the past five years. The REIT now manages 2,130 properties, 995 of which are in sole ownership.

The question is whether Extra Space has painted itself into a corner with debt utilization. It has $6.3 billion in debt and $58 million in cash. Interest expense of $47 million accounted for about 10% of revenue for the first six months of 2022. The good news is that interest expense isn’t terribly high at 10% of earnings for a REIT, and it has a debt coverage ratio of over 6 — it probably won’t have any trouble paying off its current debt.

The bad news is that around $1.6 billion of the debt is floating rate, meaning payments will increase as interest rates rise, with another $1.5 billion due by 2026.

That means nearly half the total debt, plus any new debt used to buy more real estate, will soon have a far higher interest rate. And the only way for Extra Space to raise money to pay down debt is to buy more properties to generate more cash flow.

The second part of the problem is the rating. Years of consistent revenue and dividend growth have made the stock popular, and it currently trades at 25 times management’s best-case estimate for 2022 cash flow. There are many attractive REITs trading at much lower multiples that don’t have worrisome balance sheets.

2. Boston Properties

Boston Properties is an office REIT that has struggled with increases in remote working during the pandemic. Unlike Extra Space, the price-to-cash flow ratio is okay at around 12. But like Extra Space, it’s laden with debt.

The REIT has $13.6 billion in consolidated debt and approximately $635 million in cash or equivalent. Interest expense of $104 million represents 13% of revenue. 93.5% of that debt has a fixed interest rate, but over $4 billion is due by 2026.

As a veteran REIT with arguably better real estate (high-rise office buildings versus self-storage facilities) as collateral, Boston Properties has a slightly better balance sheet than Extra Space. But the income statement certainly isn’t.

2021 revenue was lower than 2019, and trailing-12-month revenue was basically flat with 2019 numbers. Meanwhile, the REIT still has over 5 million square feet of available space, and that number has increased over the most recent quarter. For comparison, vacancy was less than 3 million square feet at the end of the second quarter of 2019, compared to around 5 million at the end of June a year ago.

Boston Properties could be at a crossroads. The pandemic has increased vacancy by two-thirds, and so far it has not been able to reduce vacancy significantly. It has $4 billion in debt maturing over the next few years and nearly $1 billion in adjustable-rate debt.

If it can transform the business and grow sales organically by filling existing space, it can potentially leverage that momentum to buy more properties and maintain cash flow. If it can’t, it may have to sell buildings in a bad market to pay off debts.

Mike Price has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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