Operating performance across the U.S. real estate sector was resilient in the second quarter of 2023, with earnings largely meeting or slightly exceeding our expectations. Homebuilders performed better than we expected, showing a quick recovery in demand despite elevated mortgage rates. Upgrades dominated our rating actions in recent months as we raised the ratings on several large homebuilders given better-than-expected second-quarter earnings while credit metrics remained strong.

Similarly, we saw some positive momentum on a few building materials companies, which benefited from better-than-expected residential construction activities. Those with more exposure to discretionary spending faced pressure. Rating actions were more negative for REITs as they are experiencing slower earnings and higher financing costs, pressuring credit metrics. We lowered the ratings on two office REITs to below investment grade and maintain a strong negative bias for office REITs.

We revised our U.S. GDP growth forecast slightly higher in late June and now expect 1.7% growth for 2023 and 1.3% in 2024, and no longer forecast a recession. We expect economic growth will remain slow, suppressed by higher than normal inflation but with the labor market remaining tight (the unemployment rate remained near a 50-year low at 3.6% in July). We expect the Federal Funds Rate to peak at 5.2% in 2024, with gradual rate cuts thereafter as prices begin to stabilize.

The higher-for-longer interest rate environment will likely remain a significant headwind for the real estate sector for the remainder of 2023, slowing external growth and limiting access to capital markets. Refinancing remains a key risk we're monitoring given tighter credit conditions while higher financing costs will exert significant pressure on cash flow coverage metrics.

Homebuilders

We expect conditions for homebuilders will continue to normalize. Despite mortgage rates rising above 7%, homebuyers have returned to the market in the second quarter and they are acclimating to the higher rates. A low supply of homes, healthy labor market, and resilient economic outlook are driving demand for homes despite worsening affordability conditions. Most homeowners are paying much lower rates than what is currently available so they are hesitant to move. Consequently, the inventory of existing homes remains low. This has enabled homebuilders to gain market share in recent months--they accounted for 40% of new home sales in the first quarter.

While second quarter results exceeded our expectations, we still expect revenue to decline and profit margins to narrow in 2023 relative to a strong 2022. As demand recovers, we expect reduced discounts and incentives to offset some of our expected declines in operating margins and revenue declines to be more moderate than we anticipated in early 2023.

We raised the ratings on several large homebuilders in July. We upgraded Meritage and Toll Brothers to investment grade, to 'BBB-' from 'BB+', with stable outlooks. We also upgraded PulteGroup and Lennar Corp. to 'BBB' from 'BBB-', D.R. Horton to 'BBB+' from 'BBB'. Following the recent upgrades, about 24% of the homebuilders are investment grade compared with 18% at end of May 2023. While the positive bias has moderated to about 10% of ratings versus 20% a month ago, we still expect upgrades to outpace downgrades over the next year.

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Equity REITs

Operating performance for the rated equity REITs largely met our expectations for slowing earnings growth given macroeconomic headwinds. Despite challenging conditions for office real estate as the return to office has been slow, operating results for office REITs have been slightly better than expectations.

That said, occupancy pressure remains modest while leasing remains below pre-pandemic levels. Performance of other property types such as industrials, residential, and retail remain resilient given good demand and limited supply.

Downgrades (five) have outpaced upgrades (two) since June. Currently, about 15% of ratings have negative outlooks, which largely reflects our strong negative bias on office REITs. We lowered our ratings on Brandywine Realty Trust and Hudson Pacific Properties to 'BB+' from 'BBB-', with negative outlooks on both. We expect Brandywine's fixed-charge coverage ratio to deteriorate over the next year as the company refinances sizable upcoming debt.

We expect Hudson Pacific Properties' operating performance to remain challenged by deteriorating macroeconomic conditions and office headwinds, potentially limiting the company's ability to backfill near-term lease expirations and maintain a leased rate similar to peers. We also lowered our rating on Office Properties Income Trust to 'BB-' from 'BB' on weaker operating performance, higher leverage, and mounting refinancing risk, and lowered our rating on Diversified Healthcare Trust to 'CCC-' from 'CCC+' after its proposed merger with Office Properties Income Trust was terminated. Diversified Healthcare Trust faces material near-term refinancing and liquidity concerns over the next 12 months and faces borrowing constraints as it is out of compliance on one of its covenants. We also downgraded Washington Prime Group to 'CCC+' from 'B-' given significant refinancing risk. On the other hand, we raised the ratings on Extra Space Storage Inc. and Life Storage to 'BBB+' following the completion of their merger.

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Although transaction activity remains muted, we've been seeing an uptick of M&A activity with a few sizable recent transactions such as Prologis' acquisition of a $3.1 billion portfolio of industrial assets from Blackstone, Public Storage's acquisition of Simply Self Storage for 2.2 billion from Blackstone Real Estate Income Trust Inc., and Kimco's acquisition of RPT Realty for $2.1 billion. We believe transaction volume could pick up later in 2023 as interest rates stabilize.

Access to capital remains tight but has been improving compared with last year as interest rates are nearing our projected peak. Debt issuance picked up momentum, with public equity REITs issuing $32 billion of debt year to date compared with $21 billion a year ago. Equity prices remain under pressure, with public equity REITs trading at 18% discount to net asset value (NAV), resulting in a significant drop in equity issuance.

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Commercial Mortgage REITs

Operating performance for rated commercial mortgage REITs remained under pressure due to minimal new originations and declines in asset quality on macroeconomic headwinds and challenges in office loans. We expect companies will prioritize maintaining liquidity over new originations given the expected decline in property valuations and potential for margin calls. We continue to see credit quality, especially in office loans, deteriorate as borrowers have difficulty making interest payments or repaying maturing loans.

The companies we rate depend on secured financing in the form of repurchase facilities that often have an interest coverage covenant requirement. The lagging impact of rising interest rates will further reduce the cushion to interest coverage covenant requirement. That said, we expect companies will prudently work with lenders to amend the threshold by reducing it and remain covenant compliant.

We lowered the issuer credit ratings on Claros Mortgage Trust Inc. to 'B' from 'B+' with stable outlooks on Aug. 10, 2023. The downgrade reflects a decline in liquidity, which could be strained if it receives margin calls on its repurchase facilities or has to fund its unfunded commitments. Like its peers, we expect the company will hoard liquidity by scaling back originations for the rest of this year.

Earlier in the year, we downgraded KKR Real Estate Finance Trust by one notch to 'B+' with a stable outlook and revised our outlook on Blackstone Mortgage Trust to negative due to higher leverage. We expect higher rates will continue to stress commercial real estate (CRE) markets, contributing to higher cap rates and lower property valuations, and weighing on CRE lenders—particularly those with exposure to office, retail malls, and hotels.

Hence, we expect asset quality to deteriorate somewhat as the economic environment creates challenges for borrowers in the next few years—likely meaning a rise in nonaccruals and loan-loss reserves. We remain focused on credit deterioration, as it could lead to foreclosures or create the need for liquidity to meet potential margin calls.

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Building Materials

Second-quarter results were largely as expected, with slowing operating fundamentals and weakened ability to manage inflationary pressures, constraining building materials companies' profitability. Spending on renovations has come under pressure as consumers are shifting spending toward travel and dining out while contending with high interest rates and persistent inflation. Even though volumes have weakened, higher prices are providing some offset for top-line growth and profits.

New home construction activity, on the other hand, is recovering, supporting demand for building materials. We forecast housing starts of 1.4 million units in 2023 (versus prior forecast of 1.2 million) and we expect revenue declines may not be as severe as we previously anticipated. Despite weakness in the residential end market, existing backlogs will likely support nonresidential construction spending, limiting revenue declines we expect for 2023. Companies that focus on nondiscretionary products, such as roofing or HVAC, should remain more resilient than manufacturers of more discretionary products, such as kitchen cabinetry and bath wares. Increased storm activity has contributed to higher demand for repairs, particularly for roofing manufacturers and distributors.

We downgraded Stanley Black & Decker Inc. to 'A-' from 'A' with a negative outlook in August. The downgrade reflects weaker-than-expected financial performance due to inflationary pressures, high debt usage, and core business challenges that strained credit metrics. We anticipate Stanley's debt leverage will remain above 5x this year due to elevated debt levels and materially reduced EBITDA margins, with benefits from management's strategic efforts to be realized more so in 2024 than in 2023.

We revised the outlook on Builders FirstSource Inc. to positive and affirmed the 'BB' issuer credit rating as we expect the company to maintain strong margins, despite slowing residential construction activities. We also revised the outlook on American Builders & Contractors Supply Co. to positive, while affirming the 'BB' issuer credit rating based on our expectations of sustained improvement in credit measures.

We expect relative rating stability for the building materials sector given that more 90% of ratings currently have stable outlooks. However, we see potential for more negative rating actions based on slowing operating fundamentals and diminished ability to manage inflationary pressures. Given the concentration of private equity ownership, more aggressive acquisitions or shareholder returns could drive more downgrades, particularly at the lower-rated credits.

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Related Research

• Industry Top Trends Update North America: Real Estate, July 18 2023
• Industry Top Trends Update North America: Homebuilders. July 18, 2023
• Industry Top Trends Update North America: Building Materials, July 18, 2023
• Real Estate Monitor: Tightening Access To Capital Heightens Refinancing Risk, June 5, 2023
• Stressful Conditions For U.S. Commercial Real Estate Are Raising Refinancing Risks, June 5, 2023