REITS Are On Track For Solid Recovery Bolstered By Stronger Earnings

Operating metrics reached an inflection point in the second quarter, with recovery taking shape for many REITs as key operating metrics turned positive. Positive net operating income (NOI) has mostly returned while rent collection has rebounded to more than 90%--close to prepandemic levels.

Retail REITs saw the biggest rebound in NOI as the fallout from the pandemic subsided and tenant sales recovered. Leasing activity across property types is also stronger given pent-up demand.

While the rising COVID delta variant cases pose a threat to the pace of the recovery, we still expect 2021 to be a recovery year from 2020 as operating performance stabilizes for most of the REITs we rate. At this point, we don't expect widespread shutdowns of the magnitude we saw last year given the progress in reopening the economy and lessons learned while operating in pandemic conditions. Still, we don't expect the sector's credit metrics to return to prepandemic levels until at least 2022 and the path to recovery could be bumpy given the potential for more social-distancing restrictions if COVID cases surge. In our view, mandated closures, if any, would be more targeted supporting a recovery, while a shift in consumer spending could delay it.

The labor market continues to recover despite risks from the new wave of infections and the U.S. unemployment rate dropped to 5.4% compared to 10.2% a year ago. U.S. GDP reached its precrisis peak in the second quarter, and we expect it will match its precrisis growth path in the third quarter this year. Our forecasts of real GDP growth for this year and next are 6.7% and 3.7%, respectively.

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Sector Outlooks

Rental housing.  Multifamily REITs with exposure to urban markets (such as New York and San Francisco) are still under pressure given heavy concessions granted last year, resulting in significant NOI declines in the second quarter but we expect sequential improvement in the second half of the year driven by a rebound in leasing and higher rent, as renters return to the cities. Multifamily REITs in the Sun Belt performed better than their urban peers with modest positive NOI growth through the pandemic. Given the pressure on urban-located assets, we expect NOI trend for the multifamily REIT sector to remain in the negative mid-single-digit range in fiscal 2021, but we expect material improvement next year with positive NOI growth as rent and occupancy recovers. In addition, occupancy remained steady in the mid-90% area and rent collection remains high. Single-family rental and manufactured homes REITs continue to outperform its multifamily peers given robust demand, with above-average NOI growth. All multifamily REITs have stable outlooks and we recently revised the rating outlook on single-family home rental REIT American Homes 4 Rent to positive from stable. We also assigned a 'BBB' rating to manufactured housing REIT Sun Communities Inc., based on its strong operating performance and improved credit protection metrics.

Office:  Office REITs are showing improved leasing and reached a peak volume in the second quarter since the wake of the pandemic, but it remains below prepandemic levels and we expect the recovery pace to be slow. There have been gradual and modest declines in occupancy (at about a 91% average as of the second quarter) and in rental rates due to higher concessions to encourage leasing. We expect demand for office space in urban markets to be muted with occupancy and rental rates under pressure as companies rethink their office footprint in a hybrid-work environment. Life science and tech companies underpin most demand across the office space segment and some REITs such as Boston Properties and Kilroy Realty are pursuing an expansion of its life-science portfolios. The pipeline for office space under development is large, spanning across many cities and is slowly leasing up, currently averaging a healthy prepandemic level of about 70%

The growing number of COVID cases and return-to-office delays could keep demand for the gateway market at bay longer, pushing out leasing decisions until a more complete return of the office is planned, likely into next year. Office utilization also remains low in these markets, given that the workforce has been slow to return to the office so far. For example, office utilization remains in the low-30% area for a 10-city average according to Kastle Systems, which tracks office keycard entry data.

We'll continue to monitor leasing activity and the impact it has on occupancy and rents to gauge the potential fallout from remote working on the office sector. We maintain a negative rating bias on office REITs with 17% of our ratings having a negative outlook.

Retail:  Retail REITs showed a solid rebound in the second quarter following the one-year anniversary of the pandemic. We expect ongoing recovery for the rest of the year and expect NOI growth to reach the high-single- to low-teen digit range by year-end after the significant drop in 2020. Rent collection has largely recovered and is getting close to the prepandemic mid-90% area as tenants have reopened. Retail REITs have also made significant progress in the collection of deferred rent granted last year, pointing to the stabilization of the tenant base. Although leasing activity has resumed and volume increased, releasing spreads remain negative for malls. Releasing spreads remain positive for strip centers, with demand rebounding nicely and leasing volumes largely reaching prepandemic levels. Occupancy is also ticking up, including a positive trend on small-shop occupancy. The negative rating bias on retail REITs has eased and currently about 15% of our ratings have negative outlooks.

Despite rising delta variant COVID cases and the potential for retailers and restaurants to face another round of social-distancing restrictions, we think consumers will continue to spend but in different categories and at more moderate levels as pent-up demand wanes. We think the impact of a virus resurgence would pale in comparison to 2020 and that an economic recession is unlikely. We believe retail and restaurants will likely remain open with regional pockets of capacity limitations (see Just When U.S. Retailers And Restaurants Thought It Was Safe To Reopen, The Delta Variant Emerges, Aug. 2, 2021). This will likely support a sustained recovery of retail REITs in the coming months.

Health care:   Health care REITs with significant exposure to senior housing remained pressured in the second quarter, though we expect occupancy to improve sequentially after a trough in March when occupancy hit the low-70% area. The ratings on both Welltower and Ventas have negative rating outlooks (both rated at BBB+/Negative/A-2) due to significant declines in NOI over the past several quarters and the uncertain pace of recovery, particularly given the rising infection rate of delta variant COVID. For both REITs, we expect NOI growth to remain negative in fiscal 2021 but recover in 2022 as occupancy improves. The delta variant is a concern that move-ins will slow, which could cause occupancy to stall or dip again, but thus far there haven't been any setbacks. Skilled-nursing assets are recovering a bit quicker than senior housing, while medical office buildings and life science assets remain steady.

Data centers.  Tailwinds for data centers remain strong and landlords continue to perform well despite some deceleration in leasing volumes compared with 2020. Pricing is still strained, particularly for hyperscale in the U.S., but absorption of supply coming online is positive and new developments are well leased. We have a stable outlook for the sector, but we maintain a more favorable view compared with other asset classes.

Downgrades Ease As Operating Performance, Credit Metrics Recover

The negative rating bias has eased. About 16% of REITs currently have negative rating outlooks with retail and office having more (compared to 30% last year). The upgrade to downgrade ratio improved, with five upgrades to six downgrades so far this year. Some upgrades reflect the acquisition of REITs by higher-rated entities such as Weingarten by Kimco.. We recently lowered the ratings on Brookfield Property Partners to 'BBB-' from 'BBB' given its elevated debt leverage.

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Strong Capital Markets, Low Borrowing Costs Boost Credit Quality

While debt issuance softened in recent weeks due to market volatility stemming from concerns around rising COVID cases and inflationary pressure, debt issuance remains strong in 2021. REITs issued about $36 billion of debt as of July 7, compared to $45 billion during the same period last year.

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There's been a general recovery in share prices and equity issuance has rebounded. U.S. REITs have issued $12.6 billion in common shares compared to $11.5 billion for the same period. Storage, data centers, and health care trades at the widest premium. While the discount to net asset value (NAV) has recovered for retail REITs, office and lodging continue to trade at the widest discount.

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REITs are positioning themselves for growth again and have resumed their external growth strategies, with more acquisitions. Improving operating fundamentals and low borrowing costs have driven more mergers and acquisitions, and could continue for the next several quarters. Asset values remain steady, and cap rates have compressed further for some property types, including industrials and multifamily. Although valuation for office assets have declined modestly, we expect cap rates to remain relatively steady, particularly for well-leased and high-quality assets.

Related Research:

• Industry Top Trends Update: Real Estate North America, July 15, 2021
• REITrends: North America Recovery Picks Up Speed, June 10, 2021
• Property In Transition: Zooming In On the Global Office Reboot, May 6, 2021
• REITrends: North American REITs Are Reaching An Inflection Point on Path to Recovery, March 18, 2021
• Remote Working Is Testing US Office Landlords’ Credit Quality, Feb. 11, 2021