Key Takeaways
- We expect revenue growth for U.S. REITs to slow given economic pressure and increasingly tepid consumer spending.
- Rising borrowing costs and market volatility will put a damper on acquisition activity.
- At the same time, employees' reluctance to return to office will likely pressure office REITs.
- Higher mortgage rates could temper housing market demand and revenue growth for homebuilders.
- Building material companies will also see slowing demand for more discretionary products.
We expect revenue growth for REITs to slow as economic pressure builds and consumer spending is increasingly fragile. Following a period of solid recovery with operating metrics across many property types reaching pre-pandemic levels, REITs face the likely prospect of slowing growth over the next two years as record inflation pressures consumer spending and pandemic habits become rituals. The first quarter of 2022 started well, in line with our expectations, with REITs we rate reporting healthy net operating income (NOI) growth as they continue to recover from the effects of COVID-19. However, we expect the recovery to lose momentum over the next few quarters, with revenue growth moderating and labor pressures somewhat impacting expenses. Year-over-year comparisons get more challenging in upcoming quarters, and we also think there is the potential for weaker consumer spending that could pressure tenants. Given increasing headwinds caused by inflation that is at a four-decade high (the CPI rose 8.3% in April after rising 8.5% in March), S&P Global economists recently lowered our U.S. GDP growth forecast to 2.4% in 2022 compared to our previous forecast of 3.2%, while raising the odds of a recession to about 30%. We expect the Fed to even be more aggressive hiking interest rates given historically high levels of inflation, with further rate hikes projected in June and potentially July. Still, the job market remains the economic bright spot with unemployment staying just above pre-pandemic levels at 3.6% while wages are increasing. Sustained job growth should continue to support demand for real estate.
For retail REITs, high inflation could weaken tenant quality as consumers are likely to cut back on discretionary spending, particularly as the personal savings rate has fallen to levels last seen in 2008. While occupancy and rental rates for retail REITs have bounced back near pre-pandemic levels, a potential recession and weaker consumer spending could stall progress. As such, we expect occupancy gains and rent growth to slow over the next year. Properties exposed to more discretionary retailers such as restaurants, entertainment, apparel, and furniture stores (among others) could be harder hit by rising inflation as consumers prioritize their spending on essential products and services. We recently affirmed the ratings on Kimco Realty Corp. (BBB+/Stable/--) and Regency Centers Corp. (BBB+/Stable/--) and maintain stable outlooks on both given our view that their high-quality asset portfolios will support solid operating performance while they maintain disciplined growth strategies. We assigned a 'B' rating to CBL & Associates Properties Inc. and rated its term loan due 2025 at 'BB-'. CBL emerged from bankruptcy in November 2021 with a healthier balance sheet and its operating performance is stabilizing from the impacts of COVID-19. About 14% of retail REITs currently have negative outlooks, while 79% are stable and the remaining 7% are positive.
Demand for rental housing remains robust, as multifamily REITs reported record same-property NOI growth in the first quarter (12.3% average for our rated REITs) with very high occupancy levels of 96.8%, above the pre-pandemic level. We maintain a positive ratings bias for rental housing REITs with 17% of the ratings on positive outlook, reflecting strength at both single-family and multi-family rental REITs. Even with some slowdown in e-commerce growth and supply ramping up in many markets, we maintain a strong positive bias for industrial REITs with 60% of ratings on positive outlook. Other recent notable rating actions include the revision of the outlook on Ventas Inc. (BBB+/Stable/A-2) to stable as a strong recovery in senior housing property (SHOP) assets gains momentum, leading to materially stronger projected credit metrics over the next two years.
Rising borrowing costs and market volatility has curtailed capital raising. Given rising borrowing costs, we expect acquisition activity to slow as cap rates creep upward. Debt issuance slowed significantly so far in 2022 amid market volatility (chart 1) as REITs issued $19.3B of senior debt compared to $28.4 billion a year ago. Credit spreads have widened significantly, by about 85 basis points (bps) since January based on a portfolio of sample unsecured bonds issued by REITs we rate (chart 2). In terms of equity, REITs trade at about 9% discount to net asset value (NAV) as of April and recent volatility in the equity markets could dampen merger and acquisition (M&A) activity. Although share repurchases by U.S. REITs declined 44% in 2021 to $2.32 billion (from $4.16 billion in 2020), we think stock buybacks could be on the rise in 2022. Simon Property Group's board of directors authorized a $2 billion repurchase program in May 2022, and office REITs (like SL Green Realty Corp.) continue to be the most aggressive by property type given their perceived deep discount to NAV.
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Chart 2
Return to office has been slow and we expect office REITs to remain pressured due to greater adoption of remote working. Office utilization is gradually increasing but the return to the office remains slow. According to data from Kastle Systems, which tracks office usage in 10 key U.S. markets, office utilization remains steady at 43% for the cities it tracks data as of May 31, 2022. Still, the office REITs we rate reported positive NOI growth in the first quarter ended March 31, 2022, and occupancy is stabilizing, particularly for high-quality class A assets as there is a widening bifurcation of demand across class A and class B assets. Leasing velocity is improving but remains below pre-pandemic levels. We expect muted growth for office space over the next two years given that incentives to tenants (TI and leasing commission) remain higher than historical levels, pressuring effective rent. Further, slowdown in demand from tech tenants could erode leasing activity as the tech sector was a key driver of growth in office demand. Recessions have historically had a significantly negative impact on office REITs, as a contraction in jobs has historically resulted in weaker tenant demand for space. However, many office REITs are contending that increased slack in labor markets might result in more employees returning to the office, demonstrating the need for physical space. It will be interesting to see how a recessionary environment would play out, but our view is that there would almost certainly be a near-term drop in demand (like in prior cycles), potentially followed by a slightly stronger-than-normal recovery. Office REITs with significant exposure to development could also see a drag to performance if the projects take longer to lease than expected. Life science assets remain the bright spot within the office sector as demand in the life science properties remains strong, in spite of a sharp decline in the stock prices of many biotechnology stocks. Currently, 82% of rated office REITs have a stable outlook while 9% are on negative and 9% on positive.
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Rising mortgage rates could cool housing market demand, temper revenue growth, and moderate positive ratings bias for homebuilders. The homebuilders we rate reported solid operating results in the first quarter of 2022. Strong pricing power and continued demand drove healthy revenue growth and margin expansion. Despite growing risks of a recession, we think performance for the rest of 2022 is somewhat insulated given that job growth remains good for now amid the still healthy backlogs of the builders. Still, rapidly rising mortgage rates along with weaker economic growth could slow demand for homes in the next year, particularly for prospective first-time homebuyers as affordability worsens. With the 30-year fixed mortgage rate already at over 5% and potential for further increases as the Fed takes an aggressive rate hike approach, we expect the positive operating momentum for homebuilders to ease. Softer-than-expected pricing power, rising costs, and increased incentives to complete closings could pressure margins as we head into 2023.
Still, housing supply remains tight and builders are managing the pace of deliveries. Some builders 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. As the housing market slows, builders will need to manage land and development spending for growth and to plan prudently to preserve financial flexibility if the market slowdown is steeper than expected.
We expect most builders to continue adding lots in anticipation of relatively firm ongoing demand. However, the majority of these incremental purchases of future homesites are likely to be made through option contracts and joint ventures, helping to limit overall spending and risks associated with land.
We currently have 41% of the rated homebuilders on positive outlook. Given our expectations for slower growth and margin pressure, the pace of the credit metrics improvement could reverse or be delayed. As such, we expect a moderation of the positive bias in the next year. Homebuilders exercised good financial discipline before and during the pandemic which yielded stronger credit metrics and good credit buffer that should mitigate some ratings pressure.
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Building material companies could see slowing demand and further margin pressure from more limited ability to pass on costs. First-quarter results for the building material companies we rate continued to benefit from a robust backlog and we expect the remaining backlog to sustain revenue and cash flow through rest of 2022. Rating actions for the sector was mixed, with some positive and negative actions depending on companies' financial policies and ability to manage inflationary pressures. We revised the outlook on Carrier Global Corp. to positive (BBB/Positive/A-2) based on significant debt reduction, stronger-than-expected credit metrics and favorable end-market conditions for heating, ventilation, and air conditioning products (HVAC) in the U.S. We also upgraded CPG International d/b/a Azek, a composite decking provider, to 'BB-' on sustained solid demand and earnings. On the other hand, we lowered the ratings on Cook & Boardman to 'B-' due to elevated debt leverage and weakness in the commercial construction market.
A cooling housing market, high inflation, along with waning consumer confidence could pressure spending on renovations and remodel activities and limit the ability to push price increases. Building material companies have already experienced declining margins due to the sharp rise of commodity costs and supply chain bottlenecks. A weaker demand picture will further pressure margins and cash flow generation. Still, we expect companies that focus on less discretionary products such as roofing or HVAC to remain more resilient than product manufacturers of more discretionary products such as kitchen cabinetry and bathware. For distributors, high crude costs could pressure margins despite good ability to pass through cost increases so far.
About 87% of the companies we rate have stable outlooks. However, the building materials sector is largely speculative-grade (80% of ratings) and 55% are rated in the single 'B' category. Slowing operating fundamentals could pressure ratings at the lower end of the rating spectrum, particularly for those companies with limited cushion in credit metrics. A shift in financial policy, given a concentration of private equity ownership, could also pressure ratings if financial policies become more aggressive for acquisitions or shareholder returns.
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Related Research
- Closing Time: The U.S. Retail Party Ends As Consumers Push Back On Inflation, May 23, 2022
- Global Macro Update: Growth Forecasts Lowered On Longer Russia-Ukraine Conflict And Rising Inflation, May 17, 2022
- Rising Risks Could Dampen Additional Operating Improvement For U.S. Strip Center REITs, April 27, 2022
This report does not constitute a rating action.
Primary Credit Analyst: | Ana Lai, CFA, New York + 1 (212) 438 6895; ana.lai@spglobal.com |
Secondary Contacts: | Michael H Souers, New York + 1 (212) 438 2508; michael.souers@spglobal.com |
Kristina Koltunicki, New York + 1 (212) 438 7242; kristina.koltunicki@spglobal.com | |
Maurice S Austin, New York + 1 (212) 438 2077; maurice.austin@spglobal.com | |
William R Ferara, Princeton + 1 (212) 438 1776; bill.ferara@spglobal.com |
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