Storms on the horizon
Amid a stable outlook, funding concerns are emerging for US equity REITs, according to Steven Marks of Fitch Ratings
US equity REITs have adopted and maintained credit-friendly financial policies supporting a positive sector outlook since the beginning of 2015. A consistent sign of the sector’s strength in recent years has been the largely unfettered capital market access that REITs have enjoyed.
That said, equity REITs have failed to fully capitalise on the strength of the unsecured bond market to reduce their bank borrowings.
The sector has more borrowing exposure from commercial banks than before, due to banks providing issuers with a surrogate to unsecured bond offerings in the form of long-tenor, low-cost term loans, with the added benefit of no prepayment penalties, save for swap breakage costs.
Issuers have not termed out bank funding via the bond market to the same degree as in prior years. This is surprising given the strength of unsecured bond markets over the last five years.
This bank borrowing exposure could limit liquidity via commercial banking relationships should REITs need incremental bank funding. In fact, bank borrowing among REITs is now nearing highs not seen in a decade, which could increase liquidity and funding risk.
The US REIT sector has seen a significant rise in commercial bank borrowing, as of year-end 2016, bank borrowing exposure accounted for 16.5 percent of total debt, up from 8.5 percent at the end of 2010.
This level of bank borrowing exposure could constrain corporate credit quality for some issuers.
Access to multiple forms of capital is a characteristic of investment-grade REITs. As such, a weakening in the unsecured bond markets would challenge REITs to tap additional unsecured bank borrowing, given the high level of current bank borrowing.
Fitch has negatively viewed companies with less mature capital structures that rely on fewer sources of funding.
The inability of issuers to obtain cost-effective unsecured funding via the bond or bank market could cause rating downgrades or negative outlook changes.
REITs do not lack options to access long-term unsecured debt funding. While there are financial and relationship-driven reasons for accessing term loans in lieu of unsecured bonds, the unsecured REIT bond market has grown in each of the last five years.
In addition, the private placement bond market has been a secondary option for smaller issuers and for select previously public-only issuers seeking lower-cost financing.
This market strength has not been unique to the REIT sector—corporate bond issuance has been robust as well, due to shrinking risk premiums as the market has sought yield in a low interest rate environment.
Offsetting this funding concern in part, Fitch is forecasting continued strength in property-level fundamentals across most asset classes, relatively unchanged leverage profiles, and sufficient access to attractively priced equity and unsecured debt capital, underpinning our stable rating outlook for US equity REITs.
Companies are increasingly focusing on (re)development to drive earnings in the context of a competitive acquisition market, lower leverage and modest organic growth. Good property fundamentals may cause some companies to moderately increase their appetites for speculative development, particularly industrial REITs. Fitch generally views later-cycle development as having execution and funding risks. Fitch anticipates issuers will retain access to low all-in-cost secured and unsecured debt, despite expectations of increasing short-term interest rates. The property transaction market remains robust, enabling companies to fund leverage-neutral growth initiatives and improve portfolio quality via asset sales.
Fitch does not forecast US REIT leverage to change meaningfully during 2017. Proceeds from dispositions will be redeployed toward acquisitions, development or modest share repurchases, and equity issuance will be episodic. Any deleveraging will be organic as companies grow recurring operating earnings before interest, taxes, depreciation and amortisation, and retain
Fitch may be in a position to revise its sector outlook to positive if the macro environment leads to sustained job growth, improving fixed-charge coverage and strong capital market access and liquidity. Conversely, a more speculative development pipeline coupled with rising development exposures and weakening access to long-term unsecured debt could precipitate an outlook revision to negative.
Fitch Ratings: Property sector viewpoints
Fitch Ratings expects healthy and above-average US office REIT sector fundamentals in 2017. Tech-oriented markets should continue to outperform due to strong employment growth. New supply will temper the performance in markets such as San Francisco.
However, some indications of thawing in technology initial public offerings and strong venture capital fundraising suggest fundamentals will remain healthy during the near to medium term. Oil-centric Sunbelt markets will remain under pressure. Fitch’s analysis suggests same-store net operating income (SSNOI) for the office REIT sector should grow at a low single-digit rate during 2017, based on modest occupancy gains and positive new and renewal lease spreads, but will be offset in part by tenant concession costs.
Healthcare REITs’ SSNOI has continued to grow in the low single digits, despite above-average supply in senior housing and operating headwinds for skilled nursing tenants, for example, volume pressures, shorter-stays, value-based care initiatives and Department of Justice investigations into billing practices that are a priority for healthcare REITs.
Fitch expects the pressures will persist in both of these asset classes in 2017. REITs have moved quickly to reduce their exposure to skilled nursing with HCP spinning off Quality Care Properties, Welltower selling multiple large portfolios and Ventas announcing plans to sell its remaining Kindred assets after the Care Capital Properties spin-off.
Fitch expects global economic growth to moderately accelerate during 2017, a positive for industrial property fundamentals. Fitch’s world GDP growth forecast is 2.5 percent in 2016 and 2.9 percent in 2017.
However, the rise in nationalism and protectionist sentiment implied by the UK’s vote to exit the EU and Donald Trump’s US presidential election victory could lead to policies that restrict trade openness and international labour migration.
The scope for slower economic growth and supply chain reconfigurations are longer-term concerns that could lead to weaker or more volatile industrial property fundamentals as a result.
Fitch expects industrial REIT SSNOI growth to decelerate modestly during 2017, but to maintain a mid-single digit pace and exceed the REIT average. Fitch expects companies will favour development over acquisitions due to strong demand and low cap rates for core, institutional quality assets.
Lessons learned from the last recession will keep industrial REIT development exposures manageable and generally appropriate for existing ratings. Issuers will continue to limit speculative building and use dispositions proceeds to fund development on a leverage-neutral or positive basis.
The unfunded component of industrial REIT development pipelines was approximately 3 percent of gross assets at the end of 2016, compared with 8.7 percent at the 2007 prior cycle peak.
We have a neutral view toward retail fundamentals for 2017. Our rating case incorporates solid near-term trends based on favourable supply and demand balance for most retail property types, that should result in positive SSNOI growth of 1 to 3 percent.
Well-located grocery-anchored strip centres and power centres should continue to experience the strongest rent growth, given solid demand and limited new supply. Further, these property types should benefit from the recovery in small-shop space (under 10,000 square feet) demand from local and national franchise tenants.
We expect well-located Class A malls to continue to outperform Class B peers, due to stronger tenancy, occupancies and market position. Class-B malls and outlying strip centres will remain under pressure from tenant losses and flat releasing spreads.
Redevelopment remains the most attractive external investment option, as customer and tenant demand is more easily identifiable. However, rent growth will catalyse new development in select primary markets, which could place pressure on overall occupancies.
Fitch anticipates multi-family fundamentals will continue to decelerate in 2017 but remain positive across REIT portfolios broadly. Same-store net operating income growth peaked most recently at 6.9 percent in Q1 2016 and supply pressures have intensified in markets such as New York City and San Francisco.
This deceleration is in the backdrop of a cycle that has been strong, despite elevated supply. We believe constrained single-family mortgage lending has been the predominant factor driving the homeownership rate lower.
This, in turn, has boosted multi-family demand across markets, in some cases overshadowing traditional local and regional
The effect is similar to single-family home price appreciation in the run-up to the financial crisis.
Fitch maintains a stable outlook on rated multi-family REITs, as issuers have positioned their balance sheets accordingly for this point in the operating cycle. Most issuers are operating with leverage at or below their financial policies and Fitch does not expect this will change meaningfully in 2017.
Similarly, liquidity profiles have strengthened from net amounts retained from dispositions after dividends and decreasing development pipelines. Balancing this positive view of multi-family REITs’ position is the renewed uncertainty surrounding the status of the US government-sponsored entities (GSEs) Fannie Mae and Freddie Mac.
Pressures to have the GSEs exit conservatorship through an unwind, privatisation or other mechanism have been muted over the past few years and it remains to be seen how the new president will approach this topic. Regardless, the rekindling of GSE uncertainty is important, given the importance of the countercyclical liquidity they provide.