Real Estate Rating Actions Year-To-Date Have Had A Negative Bias, With Retail Leading The Pack.

Retail REIT-specific rating actions thus far in 2020 have largely been downgrades on issuers with immediate liquidity, covenant, or credit protection measure issues, as well as several outlook revisions--mostly negative. We now have negative outlooks on 29% of our rated North American retail-focused REITs (up from 10% in December 2019), largely attributable to U.S. mall and outlet centers exposed to non-essential and distressed retailers.

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Thus far in 2020, 12 rating actions on North American retail focused REITs, primarily malls, stemmed from pandemic-associated strains on cash flow and heightened retailer distress. While rent deferrals will have an immediate impact on cash flow, our ratings and outlooks are longer term in nature, particularly for our investment grade rated issuers. The majority of our rating actions have been outlook revisions, which reflect our view that, in the short term, credit protection measures could breach our triggers for downgrades for many of our issuers, but recovery prospects should support credit metrics improving from the second quarter's low point. We base this on our economists' projection of a modest recovery in 2021, with U.S. GDP improving to 5.2% following a 5.0% contraction in 2020.

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However, it's still challenging to determine the collectability of rent deferrals and their impact to a company's operating metrics (i.e., maintaining occupancy to avoid the cost of re-tenanting) and credit protection measures. The timing and degree of improvement from trough levels expected in the second quarter is also highly uncertain. Moreover, potential changes to consumer shopping habits post-COVID could impair our longer-term view of retail REIT credit quality.

Distancing, Deferrals, And Delinquencies

It remains to be seen how long rent deferrals will persist, how quickly (and if) consumers return to pre-COVID shopping habits, and what impact the recession will have on discretionary spending. Nonetheless, we expect bankruptcies and store closures to continue at an accelerated pace. In particular, we expect the second and third quarters of 2020 to feature an increase in rent deferrals and write offs of uncollectible revenue, with occupancy and re-leasing spreads challenged by amplified retail headwinds. Even as some geographies are reopening, the pace of bankruptcies and store closures is accelerating as the pandemic continues to push some already struggling retailers into bankruptcy. Rent collections over the past few months has varied by sector, with malls, outlet centers, and those with greater exposure to non-essential retailers collecting the lowest cash rents when severe lockdown measures were in place, while shopping centers and net-leased REITs had better collections from more "essential" and investment-grade tenants.

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For REITs that reported detailed breakdowns of rent collections, we observed a correlation between tenants that were physically open and paying rent (for example, 86% of Kite Realty Group Trust’s essential tenants were open in April and 93% of its essential tenants paid that month's rent) versus closed (for example, Kimco Realty Corp. received rent from just 40% of its tenants that were closed in April). That said, initial rent collections have trended upwards modestly as REITs pursued delinquent rents and settled on deferral agreements. Likewise, our retail focused net-leased REITs, with a large percentage of investment-grade tenants, reported higher rent collections than peers with weaker tenant credit quality and greater exposure to non-essential tenants (for example Realty Income Corp. reported 85% of rent collected in April, compared to EPR Properties with just 15%). Moreover, June collections appear to have rebounded slightly at shopping centers as certain geographies reopened in May.

While this bodes well for July--with the number of tenants open in some capacity at U.S. shopping centers averaging around 70% at the beginning of June (up from 40%-60% in April)--our optimism is based on the continued easing of restrictions and the reopening of retailers, which is at risk. Indeed, the phased openings of recent weeks could reverse given the rising number of cases in states that rolled back restrictions. California, for one, has reinstated some lockdown measures, affecting indoor restaurants, bars, salons, and malls, and other states could follow suit. This would slow the overall retail recovery prospects, especially for categories designated for the final phases, such as movie theaters, indoor dining, gyms, or with more focus on discretionary products, like apparel, given capacity restrictions on indoor shopping. While shopping centers have some exposure to these categories, we believe malls are most at risk, along with some net-leased REITs (particularly EPR Properties).

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Bumpy road to recovery for retail-focused REITs.

We expect significant cash flow volatility for retail REITs in 2020 followed by a gradual recovery starting in 2021. But, the road to recovery will be rocky given elevated rent deferrals, write-offs, and store closures, which could persist beyond 2020. As a result, credit metrics may not return to pre-pandemic levels until 2022. We expect malls to face heightened headwinds and believe sustained retail disruption could result in material tenant bankruptcies and write offs, potentially leading to weaker demand for the property type. However, shopping centers are better positioned, with sufficient liquidity and headroom within their credit protection measures to weather several months of rent deferrals and tenant troubles, with improvement as retail operations stabilize and somewhat normal rent collection resumes.

Differing accounting methods could hide the severity of the decline.

There are different methods that generally accepted accounting principles (GAAP) filers can use to account for COVID-related deferrals, including traditional methods (lease modifications and cash accounting) and the recently announced Financial Accounting Standards Board (FASB) elections to treat these deferrals as non-lease modifications or as variable rate payments. We expect most REIT landlords to utilize the latter options for the majority of leases since these elections were provided in response to COVID-19 to alleviate the complexity that would be required to account for all rent deferrals not originally contemplated in a lease, which would be cumbersome. We expect EBITDA (which we calculate on a cash basis) will vary by the method (or more mix of methods) a REIT adopts per their expectations for rent deferral collectability, which will vary by tenant and lease, as well as their level of conservativism when assessing tenant credit quality and the probability of repayment. If a landlord opts to treat deferrals as non-lease modifications (hence expecting to collect the majority of contracted rents under substantially similar lease terms), they will not have to re-measure for straight-line rent, leaving GAAP revenue generation intact despite deferrals impacting the timing of collection. Consequently, we expect to see a pronounced increase in accounts receivables to reflect this treatment in 2020, which should decrease over time as rents are repaid (or are potentially written off). As a result, unless companies voluntarily separate the deferrals from other changes to accounts receivable, it could be challenging to ascertain the exact cash flow impact. However, some leases will be placed on cash accounting or treated as modifications, in which case the impact of deferrals will be reflected much sooner in revenue, straight-line rent, and bad debt expense disclosure.

Thus while the impact of some deferrals will be visible initially, it may take time to see the true impact for all tenants, especially as the pandemic persists, further weakening tenant credit quality and causing additional uncollectible revenue assessments. As a result, we see more risk of write-offs in the coming months and potentially years. Given their exposure to more non-essential tenants, we expect credit protection measures of mall and outlet REITs to face the most pressure, potentially causing leverage to remain elevated. However, the impact to shopping center REITs should be shorter-lived. EBITDA declines over the next couple of quarters could temporarily push credit protection measures outside our current rating thresholds for some REITs, but we expect these conditions to improve as more normalized operations resume, provided bankruptcies remain manageable. In addition, the majority of our rated strip center REITs have deleveraged over the past few years, providing some cushion to their balance sheets.

High-quality, well-located portfolios with good quality tenants will prevail.

REITs focused on necessity-based tenants clearly had better rent collections in the second quarter than those with more non-essential tenants, which is fundamental to maintaining credit protection measures. Categories with the highest rent collections during the strict lockdowns included grocery/drug stores, hardware stores, pet stores, banks, offices/professional services, and other essential retailers. Collections from these essential tenants averaged over 80% in April (with full rent collected from the best performing categories like grocery stores and pharmacies) for our rated U.S. Shopping Center and Net-Lease REITs versus an initial overall April cash collection of around 60%. Tenants with the lowest collections included fitness, theaters, restaurants, personal services, soft goods, and other non-essential categories, which paid less than 60% of April rents, on average.

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It is too early to make any large generalizations on what this means to longer-term business prospects for retail landlords. However, we continue to believe in the importance of tenant diversification and creditworthiness, asset quality, as well as market strength (including strong demographics around centers). Therefore, a key credit risk for retail portfolios is not simply the number of "essential" retailers, but rather the percentage of vulnerable retailers we believe will not withstand a prolonged disruption (which we evaluate against the quality of a REIT's portfolio, as this will impact its ability to re-lease any vacated space at favorable rates). That being said, certain "non-essential" tenants (e.g. gyms, movie theaters) are much more vulnerable over the next few months, especially should re-openings be delayed or lockdowns reinstated.

But, we believe better-quality retail portfolios--such as those operated by our strip center REITs--have an advantage over weaker assets including those operated by smaller, private owners, in their ability to re-tenant locations. Moreover, we would expect retailers to retain more productive locations should they decide to electively rationalize their footprints, a trend we expect to continue. We do not expect malls to fare as well, and see the potential for additional retail closures to impact even the best quality properties (although not to the same extent as 'B' and 'C' malls). We view department stores as a key credit risk for malls (especially weaker quality ones), given the large spaces these occupy and the significant expense to redevelop these spaces if they become vacant.

Related Research

• COVID-19 Heat Map: Post-Crisis Credit Recovery Could Take To 2022 And Beyond For Some Sectors, June 24, 2020
• REITrends: Negative Ratings Bias Rises As North American REITs Confront Effects Of COVID-19, May 28, 2020