Cash-Flow Volatility a Secondary Issue for Most Equity REITs

By Reinor Bazarewski, Associate Director, Fitch Ratings: Revenue changes for U.S. equity REITs appear to have been generally less cyclical through the most recent economic cycle than those of traditional corporate issuers while exhibiting relatively less volatility overall.

Reinor Bazarewski Revenue changes for U.S. equity REITs appear to have been generally less cyclical through the most recent economic cycle than those of traditional corporate issuers while exhibiting relatively less volatility overall. Generally speaking, the longer the term of the real estate lease, the less exposed landlords have been to operating cash flow volatility.

That said, REIT net operating income volatility and correlation with the broader economy continue to be uneven across major asset classes. Multi-family REITs showed the highest operating volatility as measured by the change in same-store net operating income over this most recent cycle. However, apartments have generally experienced the highest growth relative to retail, office and industrial properties. The short-term nature of standard multi-family leases was the primary driver for excess volatility relative to other REIT sectors, offsetting the implicit needs-based demand drivers for apartments.

Another area worth focusing on is the volatility dispersion across the office sector. Office REITs with assets concentrated in high-barrier central business districts were more likely to see outsized growth with less volatility compared to their suburban office peers over the previous cycle. Furthermore, central business district assets in high-barrier markets usually provide greater liquidity, especially in times of economic stress. Given these factors, REITs focused on central business district assets can generally maintain weaker credit metrics at a given rating level relative to entities focused on more commodity-type suburban properties. Fitch’s analysis indicated similar results within the retail sector.

From a rating standpoint, Fitch views the relative stability of REIT operating performance favorably. The main reason is the longer-term contractual nature of the business, which generates recurring cash flows to cover fixed charges. However, this positive rating impact is largely offset by REIT requirements to distribute at least 90 percent of taxable income as dividends to shareholders, inhibiting REITs from accumulating large cash balances via internally generated free cash flow to repay indebtedness. This drives outsized dependency on consistently accessing the capital markets, which constrains further upside to REIT credit ratings.