What Does Moody’s REIT Rating Methodology Tell Us?

By Philip Kibel, Moody's Investors Service:
Moody's REIT and Other Commercial Real Estate Firms Rating Methodology Grid encompasses the key factors that drive our ratings. Moody's analysts use this grid as a starting point to evaluate the creditworthiness of a REIT or real estate operating company.

Moody’s REIT and Other Commercial Real Estate Firms Rating Methodology Grid encompasses the key factors that drive our ratings. Moody’s analysts use this grid as a starting point to evaluate the creditworthiness of a REIT or real estate operating company.

The crux of Moody’s fundamental analysis is to determine the quality, diversity and sustainability of a firm’s earnings and cash flows relative to cash needs, and to translate those judgments into the likelihood of default, and recovery rates, assuming default. Commercial real estate firms issue both unsecured debt and mortgage debt (usually non-recourse) which subordinates the claims of the unsecured creditors.

By using the grid, an analyst can estimate a rating range for a REIT or REOC and the characteristics most likely to drive an upgrade or downgrade. An analyst will also use rolling averages for grid inputs, as well as the historical trend of individual rating drivers to generate sharper insight into performance. Furthermore, pro forma information and alternate outcomes from different stress scenarios generate insight into the likely credit path of a firm.

The table below summarizes the key rating drivers and sub-factors that comprise the Moody’s Rating Grid. Moody’s has applied this rating grid to all of its rated North American REITs and REOCs. The results have been within one to two rating notches of the existing ratings except for some REITs in the lodging and healthcare sectors.

For companies in lodging and healthcare, volatility of earnings tends to influence the rating more than a strong balance sheet does. Healthcare REITs, for example, are acutely exposed to operator business volatility and government funding shifts, the two being linked, and with often-high levels of tenant concentration and performance correlation. Lodging REITs experience often-sharp cash flow volatility due to daily movements in occupancy and room rates and high property expense ratios, with particular sensitivity to economic conditions.

Moody’s rates the securities of 123 commercial real estate firms globally, which have a median rating of Baa2, at the lower end of the investment grade level.