REITs Face Late-Cycle Policy Discipline Test

Decelerating property-level income increases and rising interest rates may tempt some REITs to consider development and other external expansion moves, says Stephen Boyd of Fitch Ratings.
Stephen Boyd  Image courtesy of Fitch Ratings

Tepid internal growth and discounted stock market values for select property sectors are testing REIT financial policies this cycle, leading REITs to pursue funding avenues for external, primarily development-led, growth strategies. Despite these challenges, balanced market fundamentals for most commercial real estate property types will provide a benign and accommodating operating environment, which may provide some mitigation.

Modest same-store net operating income growth is yielding minimal incremental leverage capacity under current financial policy commitments. In this environment, development-oriented REITs find themselves better positioned given incremental net operating income from new deliveries. That said, any near-term benefit could be undercut by reloading development pipelines.

Higher interest rates increased short-term borrowing costs and reduced, or eliminated, accretive refinancing opportunities. However, unsecured maturities remain light for REITs due to the capital markets dislocation in the prior decade. Almost half of the unsecured obligations maturing this year are lower-cost, shorter-term unsecured bonds issued mid-cycle to balance maturity ladders. Accretive refinancings helped offset the negative spread by recycling disposition proceeds from higher yielding, slower growth properties into lower yielding, faster growing and less capital intensive assets in core, supply constrained markets.

Pressure on Valuations

Commercial real estate values remain high and markets liquid, notably for core, class A assets. Even so, decelerating property-level income growth and rising interest rates could pressure valuations.

Commercial real estate fundamentals are generally balanced. Industrial is enjoying strong e-commerce related demand, while retail varies from solid grocery-anchored strip centers to struggling class B malls. Health care is facing headwinds driven by changing patient care settings and government reimbursement policies. Multifamily is working to absorb excess supply, while office market performance is bifurcated by exposure to tech employment.  

Core commercial real estate property types, except industrial, face supply pressure on occupancies. At the same time, bank construction lending is tempered by high regulatory capital requirements, supporting REIT occupancies and pricing. Year-over-year, rent growth remains positive.

Supported by solid market fundamentals, and an agreeable operating environment, REITs look poised to maintain their current trajectory. For REITs that face these tests of financial policy head on and with strategic action, the near-term looks stable.