US REITs, REOCs Prepared for Uncertainty Ahead

By Philip Kibel, Associate Managing Director, Moody's Investors Service: Despite Moody's expectation that the performance of U.S. REITs and REOCs will be stable in 2017, here are the key credit issues to watch for in the year ahead.

Philip Kibel head shot 2017

As Moody’s looks ahead to 2017, we expect that performance of US REITs and REOCs will remain stable. Real estate fundamentals continue to be healthy, except for suburban office, which continues to face high vacancies, rent roll-downs and negative net operating income (NOI) growth. Most investment grade-rated REITs have solid core earnings growth. Supply and demand dynamics are stable across most sub-markets.

Despite their stability, key credit issues to watch for in 2017 include liquidity and interest rates, development and adapting to new technologies.

Liquidity

Liquidity remains robust for REITs and REOCs, specifically for investment-grade REITs. Investment-grade US REITs maintain committed lines with a diverse group of strong financial institutions, with more than 50 percent availability and ample cushion between current metrics and covenant thresholds. In addition, REITs have large, high-quality unencumbered asset pools and generally maintain well-laddered debt maturity schedules with no more than 20 percent of total debt maturities in any given year. We expect these trends to continue in 2017.

Interest rates

REIT ratings are well positioned for continued interest rate increases. We expect the 10-year US Treasury yield will rise to 2.88 percent by Dec. 31, 2017, and to 3.78 percent by Dec. 31, 2018. REITs eventually will have to refinance maturities at higher interest rates, but their debt is well-laddered and solid real estate fundamentals are generating increased cash flow, helping to offset pressures from higher interest costs. Fixed-charge coverage ratios are at historic highs, owing to improving earnings, modest overall leverage and the accrued benefits from operating in a prolonged, low interest rate environment. REITs have cushion within their existing ratings to withstand a period of gradually rising interest rates.

Development

As acquisition prices for existing properties remain high, many REITs are turning to development to increase earnings. However, strategies vary, as do the associated risks arising from these activities. Many REITs see development as an attractive growth opportunity now that commercial property prices have recovered from the financial crisis and, in many cases, have reached or exceeded pre-crisis peaks. Favorable supply/demand dynamics across most of the U.S. and a generally healthy economy are equally important in driving REITs’ appetite for new development. At the same time, the expectation of rising interest rates is causing REITs to exercise more caution when considering new projects and the associated funding risk. The likelihood that property prices are at or near their peak for this real estate cycle is another risk that figures into development strategies. Moody’s focuses on the size of REIT development pipelines and their ability to manage construction and lease-up risk.

Adapting to new technologies

Changes in technology, computing power and social media have been enabling and disrupting business models across many sectors, including real estate. REITs and other landlords have, so far, responded well to market changes by managing their tenant mix, being more selective with locations, investing in existing and new assets, and adopting new technologies to make their operations more efficient.

 

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