Pace of Rating Upgrades Set to Slow for Equity REITs
- Apr 16, 2014
U.S. equity REITs have deleveraged and strengthened their respective credit profiles over the past three years and have seen an increased amount of rating upgrades and upward Outlook revisions as a result. Those days may come to an end over time.
The upgrade/downgrade ratio among Fitch-rated REITs has been roughly 10:1 dating back to 2011. That said, initiatives designed to cut leverage from their balance sheets are largely complete and credit metrics may soon reach an inflection point.
REIT bond spreads widened materially during the worst of the global financial crisis. The significant underperformance of REIT bonds captured deteriorating property fundamentals and a lack of liquidity, among other factors. This tumultuous experience prompted REIT management teams to make a concerted effort to deleverage, improve portfolio quality, and de-risk business models. These efforts have been buttressed by improving property fundamentals as evidenced by rising occupancies, rental rates, and net operating income.
Flash forward and these improvements have led to very strong bond performance by REITs compared to both non-financial corporates and industrials. REITs trade in line with industrials and 21 basis points inside of non-financial corporates despite trading 56 basis points wide to industrials and 52 basis points wide to non-financial corporates on average over the most recent 10-year period. General corporate credit fundamentals, by contrast, have been slow to improve due in part to equity-friendly behavior including dividend and stock buybacks, offset by accretive refinancing, and improving liquidity.
Stock buybacks have also become a hot topic for REITs of late, with share prices underperforming other major indices during the latter half of 2013. Should issuers fund sizable stock buybacks with debt or asset sales, credit fundamentals could deteriorate.
Equity investors generally favor strong, investment-grade balance sheets, likely making improvement in REIT credit over the past several years a secular change. However, rising interest rates and growing development pipelines offset improving fundamentals and support a stable outlook.