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When The Credit Cycle Turns: U.S. REITs Look Ready To Handle Rising Rates

As the Federal Reserve continues to normalize monetary policy, and yields on benchmark Treasuries look set to rise accordingly, S&P Global Ratings believes that the healthy balance sheets enjoyed by most U.S. REITs we rate will allow these borrowers to withstand a gradual pace of rate increases with little effect on their credit quality.

S&P Global Ratings economists forecast two more quarter-point Fed rate hikes this year (for a total of four) and three in 2019, which would bring the benchmark federal funds rate to 3%-3.125%, up from effectively zero in the aftermath of the Great Recession. We expect the 10-year yield to reach 3.2% by year-end, 3.4% at the end of next year, and 3.5% in 2020.

We believe most U.S. REITs we rate can absorb this gradual increase in rates, given that their balance sheets hold a limited amount of floating-rate debt and have limited near-term refinancing needs.

While rising interest rates have the potential to weaken credit protection measures, particularly EBITDA interest coverage and fixed-charge coverage ratios, this risk is mitigated because our rated REIT universe consists largely of fixed-rate debt. Less than 20% of REITs we rate have debt structures with more than 25% exposure to variable-rate debt.

Meanwhile, aggregate debt maturities are manageable, in our view. Just 3% of outstanding debt comes due during the remainder of this year, followed by 7% and 11% in 2019 and 2020, respectively (see chart 1).

Chart 1

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Moreover, the overall debt-to-EBITDA ratio in the sector has improved to the lowest levels since the downturn. Since the financial crisis, total debt-to-EBITDA declined to less than 6x in 2017, from a peak of almost 8x in 2010 (see chart 2), with both cash flow growth and debt reduction contributing to this improvement.

Chart 2

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Many rated REITs have pruned their portfolios to improve the overall quality of their assets, thus enhancing cash flow growth. Growth in net operating income (NOI) averaged more than 4% from 2012-2016, and we expect this to remain positive, at around 2%-3%, this year and next. REITs have also reduced overall debt levels by applying asset-sale proceeds or funding acquisitions and development in a largely leverage-neutral way.

Lower leverage could mitigate slowing NOI growth or modest declines in NOI for sectors facing secular headwinds such as retail and office. In addition, the level of unencumbered assets has improved significantly, with the ratio of secured debt total assets measuring at just about 25% on average for the rated REITs portfolio. That gives borrowers in the sector the flexibility to seek secured financing, if needed, to refinance maturing debt when capital markets may not be available.

Rising Rates Could Threaten Some REITs' Credit Quality

Nevertheless, some REITs face relatively large maturities in the next few years, which could prove costlier to refinance as interest rates continue to rise. We see this risk as elevated for REITs with operating performances under pressure, such as CBL & Associates Properties Inc., whose 'B' quality malls have suffered amid retail distress and repositioning; and Mack-Cali Realty Corp., whose office assets have underperformed as vacancies increase and large lease expirations approach.

Only a few of the 80 rated REITs and real estate operating companies (REOC) face meaningful interest rate risk due to higher reliance on variable rate debt instruments such as term loans or mortgages. Brookfield Property Partners L.P. (BBB/Stable/--), CareTrust REIT Inc. (BB-/Stable/--), CyrusOne Inc. (BB/Positive/--) and Vornado Realty Trust (BBB+/Stable/--) have the largest exposure to floating rate debt within the rated REITs universe. While these issuers have about 30%-40% of their debt in variable rate instruments, a well laddered maturity profile could mitigate refinancing risk.

REITs Have Built Credit-Protection Cushions

Most REITs have been proactive in refinancing higher-coupon debt with lower-coupon issues, benefitting from the low-rates of the past few years, and building some cushion in debt coverage metrics.

In this light, we expect REITs we rate to be able to withstand a moderate pace of rate increases, with debt coverage ratios such as fixed charge coverage and EBITDA interest coverage weakening only modestly. We ran sensitivity analyses for scenarios in which benchmark rates rise 100, 200, and 300 basis points (bps), assessing the effects on the EBITDA/interest coverage metric. On average, EBITDA interest coverage would weaken 3% in the 100 bps scenario, 5% in the 200 bps scenario, and 7% in the 300 bps scenario (see charts 3, 4, and 5).

Given the high level of fixed-rate debt and limited refinancing exposure, most rated REITs would see limited deterioration in debt coverage. However, borrowers with a higher proportion of variable-rate debt, such as term loans and mortgages, could suffer a steeper erosion of debt coverage.

As it stands, the average debt maturity of rated REITs is about six years. The range of debt maturity is wide, with the shortest weighted average maturity at about three years and longest maturity at over 11 years.

Chart 3

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Chart 4

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Chart 5

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Credit Metrics Could Come Under Other Pressures

Given the maturity of the current credit cycle, which by some measures is the longest since World War II, REITs are likely to see decelerating organic growth, and in some cases shrinking portfolios from asset dispositions. External growth is also more difficult to achieve as assets remain expensive while the cost of capital for all REITs has been increasing.

U.S. equity prices remain under pressure with the overall public REIT sector continuing to trade below net asset value (NAV). (See chart 6.) The underperformance of REITs' equity prices reflects the sector's sensitivity to interest rates and investor preference for higher-growth sectors that are more direct beneficiaries of tax reform and increased government spending.

A prolonged period of depressed equity prices could hamper access to equity capital. This could lead REITs to issue more debt to fund growth initiatives such as development projects or acquisitions. The alternative would be to slow growth due to a lack of capital access.

In recent quarters, there has been a persistent gap in public and private valuation of real estate assets. Capitalization, or "cap," rates (the returns on investment properties based on expected income) have been fairly stable, with most property types holding up. (The exception is the retail sector, given the secular changes in the industry amid emerging e-commerce and competitive pressures.) Against this backdrop, asset values remain elevated, in our view. In fact, asset values have surpassed the peaks levels of the previous cycle and we see limited prospects for further meaningful appreciation. We think asset values could face a modest decline in property values under our base case of gradual rate increases.

Given the weakness in equity issuance, more REITs are looking to other sources of capital such as joint ventures in order to monetize assets and maintain healthy balance sheets.

Chart 6

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Cash Flow Is Stable, And Financial Discipline Remains A Priority

Among the 80 borrowers we rate in the sector, 80% have stable outlooks, while just 7% are negative, and 13% are positive. Still, there could be limited ratings upside and growing downside risks for borrowers facing operating challenges.

Despite a rising rate environment and some pressure on debt coverage ratios, we expect ratings to remain fairly resilient due to stable cash flows and healthy balance sheets. We believe positive NOI growth will mitigate some of the negative impact from rising rates, while debt leverage has generally declined for rated REITs (see charts 7, 8, and 9).

Interest rates in the U.S. have remained low for a prolonged period, and a path of normalization could threaten the credit quality of issuers facing operating challenges, significant refinancing risk or higher exposure to floating-rate debt.

In previous periods of rising rates and economic expansion, REITs have performed relatively well with upgrades to downgrades reaching more of an equilibrium in 2007. There is limited historical ratings performance in periods of rising rates given the relatively young nature of the REIT industry.

Chart 7

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Chart 8

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Chart 9

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A Robust Economy Supports Real Estate Demand And Asset Values

We expect macroeconomic trends, with both strong wage and job growth, to support stable real estate cash flows for the remainder of 2018 into 2019. S&P Global Ratings forecasts U.S. GDP accelerating to 3.0% growth in 2018 (from 2.3% growth in 2017), before declining to 2.5% growth in 2019. Employment remains strong, with estimated unemployment rates of 3.8% and 3.6% in 2018 and 2019, respectively, while consumer confidence is nearing a 17-year high. We expect GDP to benefit from tax cuts, government spending, and strong consumer demand, which should support REIT fundamentals into the next year. We continue to see the odds of a recession over the next 12 months remaining fairly low, at 10%-15%--with heightened trade tensions pushing it closer to the top of that range.

With the solid economic backdrop, we expect US REITs to continue to achieve positive NOI growth in the 2%-3% range over the next two years.

However, we are getting later in this long recovery cycle (almost ten years recovery) and we expect the impact from a gradual increase in interest rates, slowing rent growth, and modestly higher debt levels to exert modest pressure on asset values in aggregate, with weaker positioned assets to experience steeper value erosion.

We forecast U.S. GDP growth to slow to its long-run potential of 1.8% by 2020. There is also a risk that the near-term growth-inflation trade-off may be weaker than we currently expect, which could pose a problem for the Federal Reserve as it tries to normalize monetary policy without crashing the economy.

Given that REITs rely on external capital due the requirement to dividend the bulk of their taxable incomes, capital markets volatility could hamper access to capital for REITs. While debt markets have remained fairly benign with bond spreads for BBB rated credits tightening in recent months, equity prices for public REITs in the US have largely been trading below NAV, although this gap has narrowed since early 2018 from an average discount of 15% in February to 2% at the end of August.

Chart 10

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Chart 11

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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:Kristina Koltunicki, New York (1) 212-438-7242;
kristina.koltunicki@spglobal.com
Michael H Souers, New York (1) 212-438-2508;
michael.souers@spglobal.com
Writer:Joe M Maguire, New York (1) 212-438-7507;
joe.maguire@spglobal.com

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