Economic recovery supports demand for real estate despite concerns from rising inflation and rate hikes.   This steady recovery in the U.S. economy supported the recovery in the commercial real estate sector, with most property types showing improving occupancy and rental rates in the fourth quarter of 2021. U.S. economic growth surpassed expectations in the fourth quarter as the damage from the omicron variant was less than expected, consumer spending rebounded, and companies rebuilt inventories.

The Federal Reserve recently raised rates by 25 basis points (bps) and we now expect a total of six rate hikes of 25 bps each in 2022, followed by five more hikes in 2023-2024, in response to the higher and more persistent inflation. We expect the 30-year fixed mortgage rate to increase further in 2022 after reaching over 4% in recent weeks. Coupled with home price growth, this could lead to substantial increases in the monthly principal and interest payments on new mortgages, further hurting affordability and dampening demand for buyers but likely supporting growth for rental housing.

In response to market developments related to the Russia-Ukraine conflict, S&P Global Ratings revised its economic forecast lower; we now expect U.S. GDP growth of 3.2% in 2022 (from our previous estimate of 3.9%) with only a small impact from slower Russian growth. Policy developments and energy prices are pushing growth lower and we expect inflation to rise 6% this year, a 40-year high. We now see heightened risk for a recession at 20%-30%, versus 15% previously.

Given the high inflation and likely steady interest rate increases, we think there could be some downside risk and little upside potential to our revenue growth forecast in 2022 for the real estate sector given the capital intensity of the sector, stalling credit quality improvement.

We see more stabilization across the REIT sector in 2022, with expectations for good revenue growth and improvement in credit metrics.   We expect further stabilization of operating performance across the U.S. REIT sector in 2022, with above-average revenue growth and a modest improvement to credit metrics. Across the rated REIT sector, operating metrics continued to rebound in the fourth quarter of 2021 with increased occupancy and rent growth for most property types. In 2022, we expect demand for rental housing, industrial properties, and storage facilities to remain robust, while demand for office assets remains somewhat muted given the slow return to the office.

Rating activity has shifted to a more positive tone with three outlook revisions to positive so far this year. We revised the outlooks on Brixmor LLC, W. P. Carey Inc., and Duke Realty Corp. to positive given solid operating performance and improving credit metrics. On the flip side, we lowered the ratings on Federal Realty Investment Trust to 'BBB+' from 'A-' with a stable outlook given expectations for sustained elevated leverage.

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We expect recovering operating performance to support relatively stable credit quality in 2022, though a faster pace of acquisition activity or shift to more aggressive financial policies could delay the recovery and pressure some ratings. Currently, 80% of the rated REITs have stable outlooks, with the remaining 20% split almost evenly between positive and negative outlooks. Subsectors that have more of a positive bias include industrial and net-lease REITs, while subsectors with more negative rating bias remain for office and retail REITs.

While retail REITs were among the most affected by COVID-19 across the rated REITs portfolio, they have made significant progress in their recovery, achieving pre-pandemic level rent collection and approaching pre-pandemic occupancy levels. We expect solid growth in 2022, particularly for strip center REITs, while malls could still face pressure on rental growth. Office utilization should increase more significantly as the workforce returns in earnest to the office in 2022, though we still expect the office REITs to show slow recovery in leasing and rent/occupancy growth. Other property types, such as industrial and rental housing, are showing solid growth in rent and occupancy due to robust demand.

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Given the high inflationary environment, rapidly rising inflation could limit REITs' ability to raise rents, though most leases have built-in rent escalators tied to CPI or at a fixed rate. Property types facing more favorable demand such as rental housing and industrial have the ability to raise rents to largely offset inflation risks, while some office assets facing muted demand may have challenges pushing rents. As we face sustained rate hikes over the next year, asset valuations could suffer, particularly for lower-quality assets or in sectors facing secular headwinds such as retail and office.

Capital-raising activity slowed after a record year in 2021. U.S. equity REITs raised $7.17 billion through capital offerings in February 2022, down 40.6% from the amount raised a year earlier. We expect debt issuance to be below last year's levels given widening credit spreads and limited refinancing needs. There has been an increase in acquisition activity, but these have been mostly stock deals that limited the impact to financial risk profiles. High capital markets volatility could dampen REITs' access to the capital markets, limiting funding for growth. REIT stock prices traded at a 7.8% discount to consensus net asset value estimates at the end of February 2022, and we expect market volatility to persist given geopolitical risks.

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Strong demand for housing supports the positive ratings momentum for homebuilders in 2022 but home price appreciation could slow amid higher rates.   We maintain a positive rating bias in the U.S. homebuilding sector, with 58% of ratings on positive outlook. Positive rating actions continued into 2022, with several outlook revisions to positive because of significant expansion in profitability in the fourth quarter of 2021 and financial disciplines are yielding stronger ratios and a growing credit buffer. As the credit profile of the homebuilders strengthened over the past two years, several rising stars reached investment grade. Currently, 19% of our ratings on U.S. homebuilders are investment grade ('BBB-' or higher) while 45% are rated 'B' or lower. Of the rating outlooks, 16 are stable and 11 are positive. We recently revised the outlook on M/I Homes Inc. (BB-/Positive/--) and KB Home (BB/Positive/--) to positive and raised the ratings on Forestar Group Inc. (B+/Stable/--) due to their expanding profitability from strong demand and our expectations for significant improvement in credit metrics despite higher spending for growth in land and site developments.

Currently, the 30-year fixed mortgage rate is well over 4% from below 3% in early 2022, and we expect it to increase even more this year. Coupled with home price growth, this could lead to substantial increases in the monthly principal and interest payments on new mortgages, which could further lower affordability, particularly for first-time homebuyers (U.S. Housing And Mortgage Outlook 2022, Jan. 27, 2022). For example, when the 30-year mortgage rates hit 5% in late 2018, homebuilders saw a dramatic decline in demand. As mortgage rates approach 5%, monthly payment increases by over 12% or a $190 monthly payment increase relative to a 4% rate on the same mortgage amount. With median household income growing just about 5% to in 2021, substantially higher payment could curb demand, particularly for first-time buyers (chart 5). We think sustained rate hikes could dampen price growth modestly, but housing demand remains strong given the lack of available housing and other positive long-term demand drivers and strong pricing amid tight supply.

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The entry-level market, which has had the strongest tailwinds over the past two years, could be more sensitive to rising mortgage rates and this segment could face more pricing pressure as rates rise throughout the year. As mortgage rates begin rising from record lows, this could slow the price growth that has sustained margins amid higher costs and an industrywide shift to lower price points. We think slowing price growth and rising costs could limit margin expansion in 2022.

In addition, builders are managing the pace of deliveries, and some have revised their production guidance down given supply chain constraints and higher costs. Shortages in certain building materials have increased cycle times and contributed to supply constraints and the production deficit. One key question is whether homebuilders can catch up on opening communities. If they can deliver on their existing backlogs, 2022 could be another strong year.

Based on our positive rating bias for the U.S. homebuilders, we expect to upgrade several homebuilders in 2022. Their financial discipline before and during the pandemic is yielding stronger ratios and a growing credit buffer, indicating that their credit quality is improving. Even if the boom in homebuilder profits moderates in 2022, we expect that most homebuilders would sustain solid credit-protection measures with robust profitability and lower debt levels given cushion under their existing credit metrics. We expect this credit buffer to widen somewhat in 2022 because we expect year-over-year improvement in both revenues and EBITDA as homebuilders begin the year with healthy backlogs and strong demand.

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Demand for housing remains strong, pushing housing rental growth as homes become less affordable.   The rated multifamily REITs saw robust rent recovery in 2021, driving same-property net operating income (NOI) growth of 10% (on average) in the fourth quarter while occupancy averaged 96.7%, above pre-pandemic levels. We expect robust NOI growth of 10%-15% in 2022, fueled by strong rent growth in the first half of 2022 (leases that are up for renewal are well below current market rates) before reverting to the longer-term average of 3%-4% in 2023. Prospective first-time homebuyers affected by the declining affordability of housing as mortgage rate rises could delay homeownership, which should prolong the strong demand for rental housing. The increase of institutional buyers in the single-family homes market has also contributed to the surge in home prices. Rated single-family residential REITs continue to post strong results with American Homes 4 Rent (BBB-/Positive/--) and Invitation Homes Inc. (BBB-/Stable--) posting same-store NOI of 10% and 12%, respectively, in the fourth quarter of 2021. We recently affirmed our 'BBB+' ratings on Mid-America Apartment Communities Inc. (MAA) and revised our outlook to positive, reflecting MAA's stronger operating performance relative to peers since the onset of the COVID-19 pandemic, with materially lower cash flow volatility. We expect MAA to continue to generate mid- to high-single-digit-percent same-property NOI growth over the next two years, highlighting its strong cash flow stability.

Still, multifamily REITs are somewhat cyclical and sensitive to economic recessions given residents' short-term leases. Economic hardships generally result in pressure to occupancy and (in particular) rent growth, as tenants gain negotiating leverage at the time of lease renewal while landlords try to preserve occupancy as evidenced by rent declines in 2020 in gateway markets (New York and San Francisco were most affected).

Supported by strong backlogs, end-market demand for building materials issuers is likely to remain solid at least through the first half of 2022, although margins could narrow given higher costs.   Rated building materials issuers ended 2021 with strong revenue and earnings growth. End-market demand for repair and remodel activities remain positive given a healthy housing market and economic recovery. Operating momentum could lose some steam in 2022 if there is a significant weakening of consumer confidence driven by persistently high inflation, threatening household investment spending given the cyclicality of demand for building materials.

Despite strong earnings in 2021, issuers experienced declining margins due to the sharp rise of commodity costs and supply chain bottlenecks. In aggregate, producers and distributors have maintained good ability to pass on cost increases and labor costs, while general building products issuers faced more challenges. We expect some margin headwinds for a sector that relies on the pass-through of volatile commodities for earnings.

About 80% of ratings have stable outlooks. Despite strong earnings, debt leverage for the sector remains elevated due to leveraged buyouts, dividend recaps, shareholder returns, and acquisition activity, limiting ratings upside. We recently revised the outlook on Smyrna Ready Mix Concrete to positive and affirmed the 'B+' rating due to growth in EBITDA from the strength in residential and commercial construction while maintaining EBITDA margins.

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Related Research:

• Economic Outlook U.S. Q2 2022: Spring Chills, March 28, 2022
• U.S. CMBS: Remote Work And The Evolution Of Manhattan's Office Market, Feb. 3, 2022
• Industry Top Trends 2022: Real Estate, Jan. 25, 2022
• ESG Credit Indicator Report Card: Real Estate, Dec. 14, 2021