The commercial real estate (CRE) industry is not only facing slowing growth and higher funding costs but also headwinds from volatile capital market conditions and tightening access to capital. Banks remain the main lenders to CRE companies, accounting for 50% of total loans outstanding, with regional banks having an outsized exposure. The recent turmoil in the banking sector could further tighten access to credit as banks have been pulling back from new CRE lending amid concerns about credit quality. Banks' unwillingness to extend or amend loans as they mature could increase the refinancing risk for maturing debt in the next year.

From a macroeconomic standpoint, we still anticipate a shallow U.S. recession in 2023. The banking turmoil sparked by the collapse of Silicon Valley Bank in March has increased the likelihood of a hard landing for the U.S. economy if continued credit tightening further slows economic growth. We believe the weakness in the U.S. economy in 2023 will lead to softening condition in the job market later this year. We expect the current U.S. unemployment rate of 3.6% to peak at 5.4% early in 2025 before declining in late 2025. The Federal Reserve's aggressive monetary policy tightening in the face of nagging inflation, combined with secular shifts in the CRE space (particularly in the office sector), are heightening the refinancing risks for many borrowers, which is a strain that we don't believe will likely ease any time soon. However, as prices begin to stabilize, we expect the Fed will implement its first interest rate cut, since it began its recent round of tightening, in mid-2024. We forecast the fed funds rate will settle at 4.0% by late 2024 as the Fed remains committed to its "higher for longer" guidance.

REITs

Tighter lending conditions amid weaker fundamentals raises refinancing risk.

The first-quarter operating performance of REITs was mostly in line with our expectations, including showing signs of a slowdown amid the deceleration in their net operating income (NOI) expansion. Office REITs are facing increasing pressure due to the slow recovery in office utilization, weak leasing activity, and high concessions. Therefore, we still expect flat to modestly negative NOI growth for the REITs in 2023, despite their adequate performance in the first quarter. For retail REITs, tenant quality concerns are increasing, given the recent wave of retailer bankruptcies, though strip center REITs reported solid operating results and good leasing momentum, which increased their occupancy rates above pre-pandemic levels. Industrial REITs performed slightly better than we expected, supported by resilient demand and mark-to-market opportunities for rents, even as economic activity slowed. The performance of rental housing REITs moderated in the the first quarter due to difficult comparisons with their strong results in 2022, though we still expect they will improve their NOI by the mid-single digit percent area in 2023 supported by favorable fundamentals due to worsening housing affordability and limited supply. In many markets--particularly those that experienced greater housing price appreciation--it remains more economical to rent than to buy.

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The negative ratings bias increased in the the first quarter, given that 16% of our ratings had a negative outlook or were on CreditWatch negative while 81% had a stable outlook and 3% had a positive outlook. This elevated poportion of negative outlooks reflects the recent negative rating actions we have taken in the office sector. We currently have negative outlooks on about 50% of our rated office REITs, which indicate the potential for downgrades in the next year, with some becoming fallen angels if the recovery in their credit metrics is weaker than we expect. We maintain negative outlooks on Boston Properties Inc. (BBB+/Negative/--), Piedmont Office Realty Trust Inc. (BBB/Negative/--), Brandywine Realty Trust (BBB-/Negative/--), and Vornado Realty Trust (BBB-/Negative/--), while our ratings on Hudson Pacific Properties Inc. (BBB-/Watch Neg/--) remain on CreditWatch with negative implications.

We're seeing more merger and acquisition (M&A) transactions amid expectations for a more-stable interest rate environment. We placed our ratings on Extra Space Storage Inc. (BBB/Watch Pos/--) and Life Storage Inc. (BBB/Watch Pos/--) on CreditWatch positive following the announcement of their merger because we expect Extra Space will benefit from enhanced scale and cost efficiencies. We also anticipate the transaction will be leverage neutral because it is a stock-for-stock deal. Additionally, we placed our ratings on Necessity Retail REIT Inc. (BB/Watch Pos/--) on CreditWatch positive following on the announcement that it had entered into a definitive agreement to be acquired by higher-rated Global Net Lease Inc. (BB+/Stable/--). While neutral to the rating, Regency Centers Corp. (BBB+/Stable/--) also announced that it is acquiring Urstadt Biddle Properties Inc. (not rated) through an all-stock transaction valued at $1.4 billion.

The volatility in the capital markets, with widening bond spreads and steep discounts to the net asset values (NAVs) of publicly traded REITs, will remain challenging for some REITs. U.S. REITs face approximately $14 billion of debt maturing this year and $23 billion coming due in 2024, with the maturity walls expanding in the following years (see chart 3). Despite tightening market conditions, we believe the majority of REITs have manageable debt maturity profiles. Still, the office sector faces greater challenges, given their weakening fundamentals and greater valuation pressure. The aggregate debt maturities for our rated office REITs stood at $4.1 billion in 2023 and $3.7 billion in 2024 as of Dec. 31, 2022, which represented 6.9% and 6.4% of office debt maturities, respectively.

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Homebuilders

Low inventory and some pull back on incentives could mitigate EBITDA declines.

As expected, there was a general decline in homebuilders' revenue and margins in the first quarter, given the effects of rising rates and the weaker economic outlook. However, their performance was not as bad as we had anticipated due to limited inventory and resilient demand from buyers. The inventory of existing homes remains low, which enabled the builders to gain market share in recent months (accounting for 40% of new home sales in the first quarter). Consumers are also adjusting to much-higher mortgage rates (the average 30-year mortgage rate remains above 6% ), which builders have attempted to counteract with lower home prices and higher incentives during the spring selling season. We had expected revenue declines of 20%-30% and EBITDA contractions of 25%-30% for our rated homebuilders in 2023. That said, given their stronger-than-anticipated start to the year, we now think the declines will be more moderate, with revenue and EBITDA falling by the lower end of our forecast ranges. Still, the performance of each issuer could differ based on their market, customer, and product focus. Nonetheless, cancellation rates are trending down amid signs that conditions might be stabilizing, while some builders are pulling back on incentives and starting to raise prices--albeit by a small amount--in some markets.

Despite our expectation for declining EBITDA in 2023, homebuilders have increased their cash balances and reduced debt, which has provided them with a significant cushion relative to our downgrade triggers. In addition, reduced working capital usage, as builders pull back on land purchases, could also become a source of cash and support their financial flexibility.

We currently have positive outlooks on about 30% of our rated homebuilders. The positive rating bias has moderated a bit since early 2023, given our expectation for a weaker performance. In April, we revised our outlook on KB Home (BB/Stable/--) to stable from positive and affirmed our issuer credit rating to reflect our expectation for lower EBITDA, amid slowing housing demand, and debt to EBITDA increasing to the mid-2x area in 2023 (from 1.4x as of the end of 2022).

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Building Materials

Deteriorating margins and earnings could pressure our ratings at the lower end of the spectrum.

The first-quarter operating results of our rated building material issuers were largely in line with our expectations, with their revenue and profits declining as the housing market cooled and consumers pulled back. While the decline in the housing market has not been as sharp as feared, we still expect modest declines in revenue (about 5%-10%) and narrowing profit margins, with EBITDA declining by the 10%-15% range, due to slowing demand for home repairs and construction amid persistent cost pressures. Commodity, labor, and delivery costs remain constraining factors for the profitability of building material issuers because these headwinds have diminished their ability to pass on costs to their customers. The performance of each building materials issuer will vary based on their end markets and product exposure. In particular, we forecast issuers exposed to the aggregates segment will remain more resilient than those exposed to discretionary products and new home construction. Given the expansion in residential multi-family construction and expectations for an increase in nonresidential spending, due to investments in infrastructure projects, some of the declines in the cyclical single-family residential end market may be less severe than we previously projected. In fact, we have already seen signs that increasing spending on infrastructure projects is contributing to improvements in their backlogs and revenue outlook.

We expect a rising negative rating bias over the next year because the sector faces weaker earnings and higher financing costs. We currently have stable outlooks on 95% of our rated issuers, negative outlooks on 3%, and positive outlooks on 2%. We think the rating pressure facing lower-rated issuers will increase, given their high debt leverage, the expansion in financing costs, and--in some cases--their limited credit metric cushions relative to our downgrade triggers. (for more info, see "Rating Pressure Grows For Building Materials Issuers Rated 'B-'"). We currently rate nine building material issuers (or 15% of our rated building materials sector) at the 'B-' level. Limited debt maturities in the next year and a reduction in their working capital investments (from slower conditions and deflating commodity costs) would provide these issuers with some support through improvements in their free cash flow generation and liquidity.

Over the last few months, we lowered our long-term issuer credit rating on Fortune Brands Innovations Inc. (BBB/Stable/A-2) To 'BBB' From 'BBB+' following the spin-off of its cabinet business, which diminished is scale, scope, and diversity. We also placed our ratings on Werner FinCo L.P. (CCC+/Watch Pos/--) on CreditWatch positive on its proposed debt refinancing. In addition, we assigned our 'BB' issuer credit rating to Knife River Corp. (BB/Stable/--) following its spinoff From MDU Resources Group Inc. (BBB+/Developing/A-2).

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