REIT unsecured notes carry four incurrence tests on cost-based assets. Converting each ratio into dollars shows which one binds and how much the REIT can still borrow.
Test the four standard unsecured note covenants on the indenture's own definitions: total debt and secured debt over undepreciated total assets, unencumbered assets over unsecured debt, and income available for debt service over debt service. For an illustrative REIT with 4,000 of debt against 8,200 of undepreciated assets, the binding test is total debt at 48.8 per cent against a 60 per cent limit: 920 of headroom for debt that buys nothing, 2,300 for debt that buys property. On the net book balance sheet the same ratio reads 59.7 per cent, which is not the test.
Worked in full in REIT Analysis and Valuation by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Most US REITs that issue unsecured bonds sign up to a similar set of incurrence covenants. They are not tested every quarter like a bank loan's maintenance covenants: they bite when the REIT wants to incur new debt, and a REIT that cannot pass them cannot borrow. That makes the headroom a capital allocation number, not only a credit one. The figures below are illustrative and the limits are the common ones; every indenture has its own definitions, and those govern.
| Input | Value |
|---|---|
| Real estate at undepreciated cost | 8,000 |
| Accumulated depreciation | 1,500 |
| Cash and other qualifying assets | 200 |
| Unencumbered real estate, at undepreciated cost | 6,400 |
| Secured debt (mortgages) | 900 |
| Unsecured debt (notes, term loan, revolver) | 3,100 |
| Consolidated income available for debt service | 620 |
| Annual debt service | 165 |
| Illustrative market value of the properties | 10,500 |
Total assets = undepreciated real estate + other assets = 8,000 + 200 = 8,200
Unencumbered assets = 6,400 + 200 = 6,600
Indentures add back accumulated depreciation and usually exclude intangibles and receivables. The 1,500 of depreciation is not in the balance sheet total, but it is in the covenant total. Market value plays no part.
| Test | Calculation | Ratio | Limit |
|---|---|---|---|
| Total debt to total assets | 4,000 / 8,200 | 48.8% | 60% max |
| Secured debt to total assets | 900 / 8,200 | 11.0% | 40% max |
| Unencumbered assets to unsecured debt | 6,600 / 3,100 | 212.9% | 150% min |
| Debt service coverage | 620 / 165 | 3.76x | 1.5x min |
In Excel, with debt in B2, undepreciated real estate in B3 and other assets in B4: =B2/(B3+B4). The covenant compliance certificate attached to each quarterly report usually prints these four lines; rebuilding them from the filings is the check.
A ratio well inside its limit says little until it is converted into the debt the REIT can still raise. That depends on what the new debt is used for.
Debt that buys nothing (buyback, special dividend): 60% × 8,200 − 4,000 = 920
Debt that buys property at cost: (60% × 8,200 − 4,000) ÷ (1 − 60%) = 2,300
When the borrowed money buys an asset, the numerator and the denominator rise together, so the capacity is the simple gap divided by one minus the limit. After 2,300 of debt-funded acquisitions the ratio is exactly 60.0 per cent.
| Test | Debt that buys nothing | Debt that buys unencumbered property |
|---|---|---|
| Total debt, 60% | 920 | 2,300 |
| Secured debt, 40% | 2,380 | more |
| Unencumbered assets, 150% | 1,300 | 3,900 |
The unencumbered asset test allows unsecured debt up to 6,600 ÷ 1.5 = 4,400, so 1,300 more if nothing is bought, or (6,600 − 1.5 × 3,100) ÷ 0.5 = 3,900 if the debt buys unencumbered property. The total debt test binds first in both cases, at 920 and 2,300.
Coverage is measured on income, not assets. Income available for debt service can fall to 1.5 × 165 = 247.5, a fall of 60.1 per cent, before the test fails. Or debt service can rise to 620 ÷ 1.5 = 413.3, which on 4,000 of debt is an average rate of 10.3 per cent against 4.125 per cent today. For this REIT, coverage is not where the constraint lies.
| Event | Total debt ratio | Unencumbered ratio |
|---|---|---|
| Base case | 48.8% | 212.9% |
| Market values fall 20% | 48.8% | 212.9% |
| Impairment of 500 on an unencumbered asset | 51.9% | 196.8% |
| Sell property costing 1,000 for 1,300, repay unsecured debt | 37.5% | 311.1% |
The cost basis makes the covenants sticky in both directions. A 20 per cent fall in market values leaves them untouched, while the market loan to value moves from 37.4 to 46.5 per cent. Only an impairment, which writes the cost basis down, reaches the covenant. A sale above cost works the other way: the REIT gives up 1,000 of covenant assets and repays 1,300 of debt, so the ratio drops to 37.5 per cent. Selling old, low-cost assets above their cost basis is a quick way to rebuild headroom, and one reason long-held portfolios tend to sit well inside these tests.
Coverage tests usually run pro forma: the new debt's interest goes into debt service and the acquired property's income into the numerator, as if both had been there for the full four quarters. An acquisition bought at a 6 per cent yield with debt costing 5 per cent adds income at 1.2 times its interest: positive in dollars, but it pulls the ratio down from 3.76x because the new slice is covered less well than the old.
Testing on the wrong asset base. An analyst who divides debt by balance sheet total assets, net of 1,500 of depreciation, gets 4,000 ÷ 6,700 = 59.7 per cent and concludes the REIT is a whisker from breach. On the indenture's undepreciated base it is at 48.8 per cent with 920 of room. The opposite error is using market value: 4,000 ÷ 10,700 = 37.4 per cent overstates the room because the covenant never sees the appreciation. Leverage on market value is the right measure of risk, as in EPRA LTV; the cost-based ratio is the right measure of what the REIT is allowed to do. For a maintenance covenant on a loan, the arithmetic is in how to calculate covenant headroom.
Rebuild the four tests on undepreciated cost, convert each into dollars, and separate debt that buys assets from debt that does not. Here the total debt test binds at 920 for a buyback and 2,300 for acquisitions, long before coverage or the unencumbered pool. REIT Analysis and Valuation puts the balance sheet on one page with the maturity ladder and covenant headroom, and the free workbooks for the book include that working document with the rest of the analysis.
Four incurrence tests are common: total debt no more than 60 per cent of total assets, secured debt no more than 40 per cent, unencumbered assets at least 150 per cent of unsecured debt, and income available for debt service at least 1.5x debt service. In the illustrative case the REIT stands at 48.8 per cent, 11.0 per cent, 212.9 per cent and 3.76x.
Usually neither market value nor net book value: total assets are undepreciated cost, real estate before accumulated depreciation. That is why a 20 per cent fall in market values leaves the illustrative 48.8 per cent ratio unchanged, while an impairment of 500 lifts it to 51.9 per cent. Each indenture's definitions govern.
A maintenance covenant must hold every quarter, and a breach is a default. An incurrence covenant is tested only when the REIT takes on new debt: failing it blocks the borrowing rather than triggering a default. Bond covenants are typically incurrence tests, so headroom is measured in debt capacity, here 920 or 2,300.
This article is one calculation from REIT Analysis and Valuation. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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