Economic Health Remains the X-Factor for Direction of U.S. Equity REITs

By Steven Marks, Head of U.S. REITs, Fitch Ratings

There is a good likelihood that the rating outlook for U.S. equity REITs will remain stable for the remainder of 2011.


By Steven Marks,
Head of U.S. REITs, Fitch Ratings

There is a good likelihood that the rating outlook for U.S. equity REITs will remain stable for the remainder of 2011. A confluence of factors, though, may result in an outlook revision. Chief among those factors is the direction of the broader U.S. economy.

Commercial real estate fundamentals are slowly improving for some property types at a time when equity REITs are still enjoying strong capital market access. A notable sticking point, however, remains leverage. High leverage has long been an impediment to improved REIT credit performance. However, if leverage comes down en masse, it would bolster equity REITs’ already-strong liquidity footing and possibly result in Fitch revising its sector-wide outlook to positive heading into 2012.

The shift to positive may also be influenced by improving fixed-charge coverage levels; continued strong capital markets access and liquidity levels; positive same-store net operating income growth for several consecutive quarters; and an improving economy and sustained job growth that would drive demand for space.

Alternatively, it’s the very same broader economy that may result in Fitch revising the sector outlook to negative. While the U.S. economic recovery was on track for a slow but steady recovery during the first half of this year, the stagnant housing market and still-declining home prices are signs that the economy remains weighed down by substantial structural headwinds.

So Fitch’s view on equity REITs may skew negative if capital market access weakens to late 2008-early 2009 levels; REITs begin embracing riskier strategies such as speculative development; leverage increases; property-level fundamentals weaken; or REITs increase common-stock dividends to a level that significantly cuts into retained cash flows.

The stable outlook holds for each of the major REIT property types. Improved property fundamentals have gained traction for multifamily REITs, while liquidity and capital market access remain solid. Those same positive attributes are also in the cards for central business district office REITs. Even in sub-sectors where property fundamentals remain negative, there are signs that those indicators beginning to turn for the better, which is good news for industrial REITs. While fundamentals are likely to remain weak for retail and suburban office REITs, improved balance sheets and capitalization, liquidity and financial flexibility are helping to offset the weakened fundamentals. The sector with the rosiest picture in the near-to-medium term is health care REITs, thanks largely to stable fundamentals and strong access to capital, together with low leverage.