Our Debt-Servicing Stress Tests

Will rising interest rates in Europe hurt funding costs for real estate investment trusts (REITs)? How would they affect the creditworthiness of real estate operating companies based in Europe? These are some of the questions investors are asking as Europe approaches a new era of increasing, rather than decreasing, interest rates.

To answer those questions, S&P Global Ratings ran stress scenarios incorporating higher floating rates over the next three years to gauge how they would affect the debt-servicing capacity, in particular for the 25 largest real estate operating companies we rate in Europe (see box below for a list of those names). Our stress tests assumed an overnight increase in floating interest rates of 100, 200, and 300 basis points (bps) in response to actions by European monetary authorities.

We found a very limited effect on the companies' funding costs and coverage ratios, thanks to limited refinancing needs and well-hedged floating exposure--on average of more than 85%--over the next three years.

The Impact On Debt-Servicing Capacity

The two most common measures of debt-servicing capacity we use in the sector are EBITDA interest coverage and fixed-charge cover. We calculate the first as S&P Global Ratings adjusted EBITDA to interest expenses and the second as adjusted EBITDA to debt-servicing obligations, which is the sum of interest expenses and of any debt amortization obligation in the coming 12 months. Both ratios qualify as core ratios in our corporate rating methodology for the assessment of a company's financial profile.

We found that both metrics would remain largely unchanged in a stress scenario where central banks in Europe would trigger a sudden and abrupt rise in interest rates. As a reminder, the Bank of England started increasing rates in November 2017 and the European Central Bank (ECB) is guiding for a first increase toward the end of 2019. In June this year, the ECB announced it will stop buying additional assets at the end of December 2018, a clear sign paving the way for future rate hikes. S&P Global Ratings' economists in Europe expect the first rate hike in the third quarter of 2019 and a very gradual increase in the ECB policy rate to happen from then on. While the ECB will stop net asset purchases by the end of this year, our economists think it will still reinvest maturing securities at least until the end of 2020.

The third core ratio we use under our corporate methodology criteria, debt to EBITDA, would obviously be unaffected as it measures a company's operating earnings capacity (S&P Global Ratings adjusted EBITDA) against its overall stock of debt (unaffected by a rise in rates).

Chart 1

In our most extreme scenario of a 300 bps rise in rates, the impact is slightly more visible. However, the overall impact remains limited. No company would see a significant drop in its EBITDA interest coverage ratio such that it would require a change for the worse in its financial profile. The reason? Most REITs' debt in Europe is now fixed or hedged. Most of them are funded on a fixed-rate basis with a rather long weighted-average debt maturity, typically exceeding five years (see table 1).

Table 1

Expanding our stress scenario to the full rated universe in the sector in Europe gives us similar results. Running sensitivity analyses for scenarios where benchmark rates rise 100, 200, and 300 bps, EBITDA interest coverage would weaken 5% on average in the 100 bps scenario, 10% in the 200 bps scenario, and 13% in the 300 bps scenario (see charts 2-4).

Chart 2

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Over the past few years, the debt profile of European real estate operating companies has largely improved mainly because they have actively refinanced their debt maturities. Their average debt maturity exceeds more than five years for all of the four segments tested (retail, office, residential, and logistics). Since 2013, most have used the one-off historical opportunity of extremely low rates to issue mostly unsecured, long-dated, fixed-rate bonds, to lock in extremely low costs of funding.

In addition, for that portion of debt which is floating, companies have contracted hedges through caps or interest rate swaps. The maturity of these hedges has also been extended out as much as possible, and it is very common to see the average maturity of the hedging contracts exceeding three years. Even on the floating portion of their debt, REITs are basically protected against any effect from an interest rate increase decided by the ECB until end of 2020. These hedges are rolled over regularly, continuously pushing out that impact.

Overall, in our tested universe, we see no single name that would have more than 30% exposure to floating rates, meaning that in the worst case, 70% of outstanding debt is fixed or hedged. This explains the reassuring results of our stress tests.

Downward Pressure On REIT Portfolio Values

A more important side effect of an increase in interest rates would likely be the downward pressure on the portfolio values of REITs.

The correlation between an increase in interest rates and portfolio value is company-specific because it is captured in its own proprietary capitalization rate. Furthermore, disclosures on that sensitivity differ from one company to the next. And, some companies don't even report it. When they do, the quality of reporting and level of transparency is far from thorough. When available, disclosures link an increase in the discount or capitalization rate (say, by 100 bps) to an estimated impact on portfolio value (typically shown as a percentage decline). In addition, sensitivity is nonlinear as the first 100 bps in the movement of interest rates would likely have a bigger percentage impact on portfolio values than a shift from 100 to 200 bps.

Finally such a correlation is by nature theoretical: It assumes an increase in interest rates overnight, with no offsetting events. In particular, it assumes no inflation and no pick-up in rents. The reality is likely to be different: first, rents will follow inflation; second, lower valuations will mean higher yields for the asset class, making it more attractive to investors in the sale and purchase real estate market.

The magnitude of the effect coming from any change in interest rates is large. In terms of sensitivity, discount rates represent the most decisive factor in any discounted cash flow valuation. That's because they figure into the net present value calculation of property operating income over the discount period (typically 10 years) and its terminal value. A 25 bps change in the discount rate can very easily come to represent a 5% variation in any given real estate asset or portfolio (see table 2).

Table 2

To test the resilience of our ratings to such an external shock, we tested arbitrary declines in portfolio values. Across our sample, a 5% drop in portfolio value is unlikely to trigger any rating actions; a 10% fall is likely to cause at least a few revisions to the outlooks and only a handful of downgrades, if any. Downgrades would be more likely and could represent half of our tested rated universe if asset values drop by an average 20%. That's because such a drop in asset values would raise a key credit metric: median debt/debt plus equity (D/D+E) (see charts 5-7). However, downgrades would likely be limited to a single notch.

Chart 5

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By segment, we expect a stress on asset values would affect residential the most. That's because headroom in the ratings is less than for other diversified REITs. That's especially true for the German residential segment, which has been leveraging up in recent years, partly as a result of M&As and sector consolidation.

On a name-by name basis, given the volatility of D/D+E in a stressed valuations scenario, we consider headroom to the downgrade trigger level, which we commonly highlight in our rating rationales, to be important to ratings stability.

A 20% stress on a portfolio is obviously not a benign scenario. That's comparable to what was observed throughout the 2007-2009 financial crisis. Values of pan-European portfolios typically fell by a percentage in the low double-digits, with bigger falls in some jurisdictions (for example Spain) and segments.

One benefit to using D/D+E is that it is a much earlier indicator of market pressure than debt to EBITDA. Debt to EBITDA is more static, since real estate assets are leased under multiyear contracts, primarily on a fixed minimum rent basis. As a result, downward pressure on rents only appears when assets are vacated and come back on the market. Whereas it may take years for debt to EBITDA to capture a change in market conditions, D/D+E will react more quickly to a dearth of transactions or a dip in sales prices in any given market.

Note that the stress test we performed is primarily based on financial ratios. If a dearth of transactions and depressed prices were to affect a market segment or a specific geography in the long run, we obviously would have the extra flexibility in our ratings approach to revise our business profile assessment for the companies concerned.

Buffers And Mitigants That Should Soften The Impact

We believe several buffers are in place that should protect real estate asset values in Europe against rising interest rates: widespread indexation of rents to inflation, a currently high risk premium between discount rates and risk-free rates, and generally prudent assumptions that independent appraisers use in their line-by-line valuation process.

In Europe, commercial rents are widely indexed to inflation. According to contract terms, rents are fixed but tied to follow, with a possible time lag, a public consumer price or construction index. As a result, rents in Europe are economically hedged against a rate increase.

It would take an external shock (for example, a new eurozone sovereign crisis, massive trade issues, a credit crunch, or a sudden drop in equity prices) for a sudden spike in rates to be unaccompanied by a rise in inflation.

For 2018, we note that indexation should be in the 1%-2% range across Western Europe, almost double what it was in 2017. In the next two years, the time lag should act in favor of commercial property owners. That's because recent inflation numbers open the way to low- to mid-single-digit percentage rent increases in the sector, while the ECB recently indicated that interest rates should not rise before the end of 2019. Importantly, the latest projections released by the ECB point to a faster rise in inflation than six months ago, with annual headline inflation at 1.7% in 2018, 2019, and 2020. In the short term, some of the rise in inflation is linked to higher oil prices and a weaker euro, but by 2020 the ECB sees core inflation reaching 1.9%, in line with its target.

Even if the long period of yield compression that started in 2013 is behind us, supply constraints in large European cities and a supportive economic outlook still open the way to reasonable rent increases in coming years.

While widely observed for commercial assets, indexation to inflation is much less common for residential assets, which could make the segment more exposed to a scenario of rate increases. In Germany at least, the largest market for residential REITs, we observe that tenants occupy their flats for a long time and rents for our rated residential players are still about 10%-15% below market levels. This offers upside potential or, in a stress scenario, downside protection if market rents start to fall. In addition, the risk premium for REITs is currently at historically high levels, sufficiently wide to absorb an increase in sovereign risk-free rates with no need to adjust discount rates upward. We note that most REITs in Europe currently report average discount rates for their portfolio exceeding yields achieved upon disposal of similar assets. Plus, REITs' average discount rate is currently much higher than the costs of funding and risk-free rates. The risk premium embedded in the discount rate used by appraisers seems wide enough to absorb a sudden spike in rates that central banks could initiate. Prior to the 2008-2009 recession, risk premiums for European REITS were historically low. This is not the case currently with discount rates (typically around 5%) representing a 350-400 bps premium over risk-free rates and a 250-300 bps premium over funding costs.

The roles of fair-value reporting

Unlike U.S. GAAP, International Financial Reporting Standards (IFRS) require that REITs and real estate operating companies in Europe report the value of their real estate assets on a fair-value basis. Independent certified appraisers, referring to registered standards, provide those valuations for each asset, building by building or shopping center by shopping center. To do so, they incorporate the specifics of the rental contracts under which the assets are leased but also refer to prices of most recent sales of similar properties. These valuations are commonly used for transaction purposes when an asset comes up for sale, setting an independent benchmark, if not a floor, for price negotiations.

Property valuation in the U.K. is regulated by the Royal Institution of Chartered Surveyors (RICS), a professional body encompassing all of the building and property-related professions. Similar bodies exist in other European countries. In Germany, for instance, real estate appraisers can qualify and become an "öffentlich bestellte und vereidigte Sachverständige" (officially appointed and sworn expert). Large REITs typically use large appraisal firms (such as JLL, Cushman & Wakefield, and BNP Paribas Real Estate, to name a few) with global reputations.

Appraisers' assumptions for discount rates, void periods, incentives, and economic rent levels, among others, are set in reference to public standards and are generally prudent. In most jurisdictions, market values are determined in accordance with International Valuation Standards (IVS or the White Book). The International Valuation Standards Council monitoring IVS is a nongovernmental organization member of the U.N. with membership that encompasses all the major national valuation standard-setters and professional associations from 41 different countries, including the American Society of Appraisers, RICS, and the Appraisal Institute of Canada.

Finally, European REITS have a long track record of selling at a premium, sometimes in the double digits, to appraised values on a variety of assets in the residential, retail, and office segments. This gives the overall market confidence that appraisals can absorb reasonable downward sensitivity. Investment volumes flowing into European real estate continue to be particularly robust in 2018. After several years of gradual tightening, there are few signs yet that market-supported yields should rise soon.

Even if interest rates start increasing, we see it as related to improving economic fundamentals accompanied by positive inflation and economic growth. Ultimately, such a combination should prove beneficial for the real estate sector and support higher rental levels--conveyed by higher occupancy rates in general--hardly consistent with any downward pressure on asset values.

Related Criteria And Research

Related criteria

• Corporate Methodology, Nov. 19, 2013
• Corporate Methodology: Ratios And Adjustments, Nov. 19, 2013

Related research

• German Housing Market Is Likely To Withstand New Regulation And Rising Rates, Aug.15, 2018
• How S&P Global Ratings Uses Asset Valuations In The European Real Estate Sector, July 24, 2018
• Key Credit Factors For The Real Estate Industry, Feb. 26, 2018