Fourth-Quarter Results Showed Improvement; Recovery Expected To Gain Traction In Second-Half 2021

REITs reported fourth-quarter results that largely met our expectations given the continued impact from the pandemic. They reported sequential improvement in rent collections to the mid-90% area, up from the low-80% area during the trough of the downturn in second-quarter 2020. Net operating income (NOI) trends are also recovering, with moderating declines. Retail REITs suffered the steepest declines with same-store NOI dropping 22% for mall/outlets and 9% for strip centers. Multifamily REITs also posted their first year of NOI declines since the Great Recession because of pressure from an urban exodus, such that NOI dropped an average of about 4% in fiscal year 2020. Industrials, data centers, and self-storage remain well-positioned, and we expect these property types to outperform the REIT sector average in 2021.

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While there is limited visibility for 2021 because many REITs are still unwilling to provide detailed guidance, we see signs of recovery emerging as the U.S. economy recovers and lockdowns ease across many markets. We expects U.S. GDP growth of 4.2% in 2021, following a 3.5% contraction in 2020 based on our assumption that vaccinations will be widespread by the end of the third quarter of 2021. We believe broader vaccination should drive an accelerating economic recovery with greater job growth in the second half of the year.

The U.S. unemployment rate ticked down to 6.2%, and the U.S. economy added 379,000 jobs in February, showing sequential improvement. Still, the U.S. labor market remains 9.5 million jobs short of the pre-pandemic peak, and leisure and hospitality employment is still 20% down from a year ago.

We expect 2021 to be a recovery year, part of a multiyear recovery for credit metrics. Credit metrics for the rated REITs have weakened because of cash flow declines in 2020, and we expect a gradual recovery over the next two years as cash flow rebounds from higher rent collection, lower deferrals, and a rebound in leasing activity.

Pandemic's Effects Will Likely Linger For Retail REITs; Secular Changes Could Slow Recovery

Retail REITs were directly hurt by government-imposed lockdowns and store closures in 2020. Rated retail REITs posted significant same-store NOI declines in fiscal 2020, with malls/outlets at the worst end of the spectrum (reported decline of 22%), while the decline was less severe for strip center REITs (9%). Retail landlords granted significant rent deferrals because of tenant distress. While retail landlords have negotiated payment terms for most of the deferrals, there is still risk that additional write-downs or cash abatements hurt operating performance in 2021. Tenant quality remains a key risk as distressed tenants (i.e., many casual dining and entertainment tenants), remain vulnerable in the recovery phase while the potential for more store closures remains. There also continues to be a divergence in the performance of malls versus strip centers. Re-leasing spreads for malls were negative, in the mid- to high-single-digit range in recent quarters, while re-leasing spreads were flat to slightly positive for strip centers as leasing activity picked up.

Following the significant drop in same-store NOI in 2020, we expect some rebound in 2021, such that same-store NOI grows in the mid-single-digit range but remains significantly below 2019 levels. We think the pace of the recovery will largely depend on the pace of widespread immunization, as well as the potential for more prolonged restrictions or lockdowns in some regions. Post-pandemic, more permanent shifts in consumer behavior to shop online versus in stores could have a lingering effect on retail REITs and further limit the pace of recovery. We recently lowered our rating on Tanger Factory Outlet Centers Inc. to 'BBB-' from 'BBB' because we expect its outlets to exhibit weaker rent rolls and occupancy, as well as a longer than previously expected recovery of its key credit metrics. We also lowered our rating on Washington Prime Group Inc. to 'D' from 'CC' on the missed interest payment on its senior notes.

The performance of net-lease REITs has remained more resilient because of the diversity of their tenant bases, steady operating metrics, and the ability to issue equity at favorable prices. These factors have supported a quicker recovery of credit metrics for net-lease REITs. We recently upgraded VEREIT Inc. to 'BBB' from 'BBB-' because credit metrics recovered and rent collections normalized as a result of the company's greater focus on high credit quality tenants compare to many of its peers.

Pressure Remains On Health Care REITs Exposed To Senior Housing

The pandemic has had an uneven effect on health care REITs. Life sciences and medical office properties exhibited steady growth trends, while senior housing assets were under tremendous stress. While skilled nursing facilities also felt the pandemic's effects--occupancy significantly declined--operating performance was relatively stable because of regulatory changes and material government support. Combined, these factors resulted in relatively stable tenant-level rent coverage and rent collection of at least 99% for our rated REITs.

We lowered our rating on Diversified Healthcare Trust in February 2021 to 'BB-' from 'BB' because of its overexposure to poorly performing senior housing operating assets and our expectation that leverage will remain higher than previously anticipated over the near to medium term. Moreover, we have maintained our negative outlooks on Welltower Inc. and Ventas Inc., given their large exposure to senior housing operating assets. However, we recently upgraded our rating on CareTrust REIT Inc. to 'BB' from 'BB-', reflecting the company's strong operating performance and improved key credit metrics throughout the pandemic.

Urban And Suburban Market Performances Are Diverging

Although the longer-term effect is highly uncertain, the pandemic greatly pressured utilization of office real estate in urban metro areas--New York City reported fourth-quarter utilization of 10%-15%. Utilization in suburban office assets has been much higher, because those assets rely less on public transportation, and social distancing is far easier. Overall, rent collection remained resilient for office REITs (unlike retail) throughout 2020, given the stability of the underlying tenants. Uncollected rents and deferrals for office REITs were largely limited to their retail exposure, while declines in NOI were mostly driven by other variable income such as parking or cleaning services. We expect some pressure on occupancy and effective rental rates once leases come up for renewal, including higher concessions. While it's far too early to assess the potential effect, remote working could significantly downsize office footprints. That said, office REITs have long weighted-average lease terms (about eight years on average), and well-staggered lease expirations and manageable leases coming up for renewal over the next couple of years (of about 8% of annualized rent annually), which limit the near-term effect of this trend on stabilized portfolios.

However, we think office REITs with large development pipelines could see more pressure from slower lease-up or lower effective rents, and they could see yields contracting. We recently lowered our rating on Vornado Realty Trust to 'BBB-' and revised the outlook on SL Green Realty Corp. to negative.

Rental Housing Sector Is Improving

We expect continued divergence of operating performance in multifamily assets for coastal gateway markets and properties located in faster-growing Sun Belt markets. We think this trend will likely remain over the foreseeable future as population migration and job growth remains more robust in the South. Sun Belt region focused multifamily REITs Mid-America Apartment Communities Inc. and Camden Property Trust posted same-property NOI of 1.2% and negative 0.4% in full-year 2020, bucking the sharper negative trend among the other rated multifamily REITs (negative 5.5%).

While densely populated urban markets will likely show significant recovery in occupancy once immunization is more widespread and employees return back to their offices, assets in these markets will likely underperform from an NOI perspective for at least the next year. In certain gateway markets such as New York City and San Francisco, landlords are offering prospective renters significant concessions including two to three months of free rent, and that will pressure rental rates over at least the next 12 months.

Negative Rating Bias Will Likely Ease, But Retail And Office REITs Still Face Pressure

The negative rating bias remains about 20% for the rated REITs sector, though the portion of retail and office REITs on negative outlook stands close to 30%. Downgrades outpaced upgrades in 2020, but the pace of downgrades was less severe than the previous downturn in 2009. However, we expect the negative rating bias to ease later 2021, as operating performance stabilizes and we gain better visibility into the recovery of credit metrics.

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REITs Maintain Solid Liquidity And Access To Debt Markets

Rated REITs have maintained solid liquidity through the pandemic, and they issued a record amount of debt in 2020 ($79 billion in 2020, up from $70 billion in 2019), mostly to refinance debt maturing over the next two to three years. However, equity issuance was significantly below 2019, as many REITs traded well below consensus net asset value estimates most of the year. As operating conditions stabilize in 2021, we expect more REITs to reinstate dividend payments after having cut or suspended dividends in second-quarter 2020, though dividends will likely remain below pre-pandemic levels. We also expect acquisition and disposition activities to pick up from low levels in 2020, given the disruption caused by the pandemic. We still believe there is potential for moderate pressure on valuation on real estate assets, given slowing cash flow growth and the potential for interest rates to rise.