- REITs faced significant earnings pressure in second-quarter 2020 due to the impact of COVID-19 and the recession. This was largely in line with our expectations for a very challenging quarter and weakening credit metrics.
- Retail and senior housing assets experienced steeper operating pressure than other property types given the direct impact of the pandemic on their utilization. Office and multifamily assets were also pressured, particularly in gateway markets, as the de-urbanization trend intensifies due to remote working practices.
- We expect a multiyear recovery in the REIT sector with credit metrics returning to pre-pandemic levels by 2022, but the recovery could be uneven and downside risk remains significant. In this downturn, tenant credit quality and asset quality are key factors in gauging recovery prospects.
- Of REIT ratings, 18% have negative outlooks, and we expect more downgrades over the next 12 months as we assess the impact of changing consumer behavior and the prospects for economic recovery on credit ratings.
- After a long and extended expansion cycle that benefited asset values and operating performance, the real estate sector now faces much uncertainty in its operating landscape over the next year. We expect pressure on cash flow to weigh on credit metrics and affect asset valuations due to weaker growth prospects. However, REITs entered this recession with lower debt leverage and more unencumbered assets than the last, which provides some cushion to ratings downside.
- REITs, like other investment-grade sectors, have maintained good access to the debt markets, bolstering liquidity. REITs have focused on preserving liquidity and mitigating the impact of lower earnings on key credit metrics through dividend cuts and curtailing both capital expenditures and acquisitions.
Second-quarter results were challenged by COVID-19, with some sectors more severely affected. REITs faced significant earnings pressure in the second quarter due to COVID-19, but results were largely in line with our expectations for a very challenging quarter, with malls, outlet centers, strip centers, and net-leased REITs facing the most pressure from rent deferrals and bad debt expense provisions. Health care REITs with exposure to senior housing assets were significantly hampered by occupancy declines largely attributable to move-in restrictions. Other sectors were less immediately affected, with industrial, office, and multifamily collecting over 95% of rents, on average.
Net operating incomes (NOI) abruptly declined in the second quarter after prolonged growth. Retail REITs reported the steepest declines in NOI for the quarter, while industrial assets were the only traditional REIT property type posting positive NOI growth. We expect NOI pressure to persist over the next year as REITs likely experience declining occupancy and rental rates while they navigate the pandemic and recession. While we expect a general deceleration of NOI declines in the next few quarters, REIT-reported figures such as NOI do not reflect the magnitude of the impact on cash flow given reporting differences and the varying degrees of conservatism they choose when reporting bad debt provisions or cash basis accounting. Given the significant amount of rent deferral to be collected in the coming months, cash flow will largely depend on the collectability of deferred rent or abatements.
We expect a gradual improvement in rent collections as the economy steadily reopens and tenants get back to business. Already, we are seeing some improvement in initial rent collection figures, with July trending above second-quarter collections since most U.S. states have reopened in some capacity. It seems that consumers are adapting to the "new normal" and tenants were able to reopen somewhat successfully, although it remains to be seen how traffic and sales will trend, especially as COVID-19 cases re-emerge. We believe that properties being open is crucial for rent collection in the hardest hit subsectors like retail. However, the ultimate collectability of rent deferrals could take longer to ascertain, and we believe a large portion of deferrals could become abatements. While the vast majority of REITs did provide some details on cash rent collection, executed deferral agreements, abatements, and provisions for bad debt expenses, the reporting and approach taken varied widely based on each company's level of conservatism and how far along they were with executing deferral agreements, as many were still outstanding. Accordingly, we expect rent collections to continue to affect credit metrics well into 2021, when most repayment schedules are set to commence. This could result in additional write offs over the coming months as REITs reassess tenant credit quality.
The retail sector remains under significant stress from rent deferrals and elevated bankruptcy risk. Thus far in 2020, retail bankruptcy activity has accelerated and eclipsed levels in 2019. While malls were the hardest hit by second-quarter bankruptcies, which include Neiman Marcus, J.C. Penney, J. Crew, Brooks Brothers, and Ascena, we do not expect shopping centers and net-leased retail REITs to be immune from the disruption (for example, Bed, Bath, and Beyond recently announced the closure of 200 locations). That being said, most bankruptcy filings so far have been retailers that struggled pre-pandemic, with the virus accelerating underlying challenges. Moreover (and with some exceptions), a large portion of these bankruptcies have been restructurings instead of liquidations, which we view as somewhat positive. However, we expect additional disruption for apparel and other retailers that were already struggling with changes in consumer shopping habits and methods before the pandemic to file for bankruptcy or close a large number of stores. We also anticipate more "nonessential" tenants (including smaller ones), such as restaurants, fitness facilities, movie theaters, could face protracted pressure from declines in discretionary income and extended periods of social distancing measures, leading to more defaults and/or closures.
Malls and outlet centers are most exposed to distressed retailers given their concentration in the apparel/department store segment, while shopping centers currently have more manageable exposure to at-risk tenant categories, although we expect watch lists to grow over coming months. This could pressure occupancy and rent growth for our rated retail REITs beyond 2020. In particular, we expect small shop occupancy to be hit by vacancies and tenant move-outs. We also expect challenged re-leasing spreads over the next several quarters (even though they largely held up in the second quarter, with most deals in the works before the virus) as many REITs may elect to keep occupancy up at properties by offering tenants higher concessions and lower rental rates. Moreover, there could be an increase in shorter-term leases, giving landlords the flexibility to mark rates to market value over the next few years as the economy stabilizes. Likewise, this gives retailers the flexibility to more quickly reassess their footprints in response to changing retail landscapes. We think the holiday season will be an important test for the viability of some retailers as well as retail formats, such as malls and outlet centers, which depend more on a favorable season to collect deferred rents starting in the beginning of 2021.
We still have a generally favorable view of well-located, grocery-anchored shopping centers but are monitoring the health of in-line tenants. Grocery stores were the primary place to source food and other necessities amid the pandemic, even if orders were fulfilled through delivery services such as Instacart. Over the past few months, grocery sales increased sharply, a trend we believe could continue as restaurant dining options remain limited and consumers continue to spend more time at home. Albertsons capitalized on this surge in demand to complete its long awaited IPO, allowing Kimco to monetize some of its investment. We expect grocers to invest additional resources into e-grocery initiatives, such as online shopping and in-store pick-up to capitalize on demand. While e-grocery penetration (which was around 2% in the U.S. before the pandemic) has increased, delivery times were slow and hard to come by at the height of the lockdowns in certain regions, demonstrating its infancy and solidifying the need for well-located grocery-anchored centers. That being said, grocery stores make up a relatively small portion of rents at shopping centers. And while they have long been useful for driving foot traffic to centers, this is less important during the pandemic where shoppers are less likely to enter stores unless they have a purchase (or return) in mind. We believe that prolonged social distancing and capacity constraints could hurt smaller and less-capitalized retailers, especially those selling discretionary products and indoor dining/entertainment.
Gateway markets will see near-term challenges affecting office and multifamily assets, but the longer-term impact remains unclear. Given the increased adoption of work-from-home practices, especially in larger cities where commuters take public transportation, there has been much discussion around office utilization and the potential for movement out of gateway cities. Over the past few months, some workers have temporarily relocated to suburban areas with more space. Moreover, there has been an uptick in housing sales in areas surrounding major cities, indicating a more permanent shift toward the suburbs for other workers. We expect gateway markets such as New York, San Francisco, and Los Angeles, for example, to face greater near-term rent and occupancy pressure given its higher sensitivity to economic cycles. During the second quarter, New York-based portfolios suffered a steeper NOI decline.
However, it remains to be seen what the longer-term impact will be and if companies will opt for offices in non-gateway markets, utilize satellite offices, or keep remote working. Some office tenants (such as tech companies Amazon and Facebook) are still betting on the longer-term viability of gateway offices by actively signing new leases. Facebook signed a long-term lease with Vornado for the entire office space in the Farley Building in mid-town Manhattan (730,000 sq. ft.). However, we expect this to differ by sector, with technology tenants looking for more space whereas other tenants, such as financial services and law firms, could reassess their footprints and downsize. In this respect, we expect that some near-term lease renewals could be signed with more flexibility, giving the tenant shorter terms and more options to opt out. There is also some evidence that sub-leasing and vacancy rates are increasing, but this seems to be more consistent with the recession and not directly tied to specific markets.
On the multifamily side, gateway markets are facing greater pressure in the near term given tenant movement. NOI declines in these markets were in the high-single-digit range compared to the low-single-digit average for multifamily. There has been some migration away from urban markets (including San Francisco and New York City) and we are seeing occupancy hold up better in suburban markets. That being said, some of this could be temporary as COVID has provided employees with greater flexibility to work remotely in the short to intermediate term (some through 2021). It remains to be seen how this plays out over the longer term and whether people opt to remain in suburban spaces. While this could pressure REITs with more urban locations, such as Equity Residential (which has 55% of its portfolio located in urban markets), REITs with more exposure to suburban locations could potentially stand to benefit. For some cities, the ending of eviction moratoriums could hurt occupancy to some extent, though it's uncertain how regulatory pressures could affect housing fundamentals over the near term. Moreover, we think that burgeoning fiscal deficits could prompt many states to raise taxes, which could accelerate migration trends away from certain markets like New York and California.
Lastly, on the retail side, REITs with greater presence near gateway markets were among the first to have their tenants placed on mandated closures and among the last to reopen, with some markets still not allowing certain tenant categories to operate, such as indoor dining and fitness centers. While this has affected tenant rent collections to a certain extent (with a strong correlation of tenant reopenings leading to higher rent collections), it does not change our view that stronger-quality assets will prevail over the long run given favorable demographics. However, shopping centers and net-leased retail assets located in suburban markets that are accessible via car could garner more traffic and normalized sales productivity in the near term versus assets near cities with more density, restrictions, and consumers wary of shopping.
Debt issuance continued at a steady pace in the second quarter as rates remain low. The investment-grade corporate bond market in the U.S. reached record levels of issuance in 2020 and REITS were no exception, raising $50 billion through July 31, 2020. While weaker cash flow prospects in the next two years could pressure real estate valuations, we don't expect a dislocation given historically low interest rates despite near-term cash flow pressure. Still, weaker-positioned assets such as retail with poor prospects will likely continue to see widening cap rates. Asset values could also be under some pressure over the next year if bank lending standards tighten.
The negative ratings bias remains as the impact of the COVID-19 pandemic and resulting recession affects REIT credit quality. We have taken 26 rating actions since early March, mostly comprising outlook revisions, as well as some downgrades within the retail, health care, office, and net-leased sectors. We expect negative rating activity to continue over the next year as we monitor the potential for a recovery in real estate demand and REITs progress in restoring credit metrics to pre-pandemic levels.
Our assessment for potential downgrades would include a review of the impact of changing consumer behavior on real estate utilization, prospects of economic recovery, and financial strategies on credit ratings. The pandemic could have a long-lasting impact on real estate utilization, particularly for retail, office, and health care assets. While e-commerce was already a threat to retailers even before the pandemic, COVID-19 is accelerating this secular change and fundamentals for the retail sector remain challenging, with ongoing erosion of tenant quality, particularly for malls. For office, the longer-term impact of remote working could weaken demand fundamentals for gateway markets and increase de-urbanization, which could also affect multifamily assets in these markets. We will continue to monitor the pace of recovery and leasing activity and evolving tenant credit quality in the coming months to determine rating changes.
We expect REITs to maintain relatively conservative financial policies as they navigate this downturn, with a focus on preserving liquidity. Many REITs have cut or suspended dividends, cut costs, and reduced capital spending or development activity to preserve cash. We currently believe most REITs have good liquidity, with adequate levels of cash or access to capital to withstand the near-term pressure. Moreover, we believe REITs have entered this recession in relatively better shape than the last, given lower debt leverage, a larger pool of unencumbered assets, and a well-laddered debt maturity profile that should help mitigate downside risks.
As of Sept. 1, 2020, we have negative outlooks on 18% of our rated REIT portfolio (our outlook horizon is generally 12-24 months). Retail makes up most of our negative outlooks, followed by office and health care. We expect downgrades to increase over the next year.
|U.S. REIT Rating Actions: May 21, 2020-Aug. 26, 2020|
Service Properties Trust
|Nicolas Villa||Aug. 26, 2020||BB-/Negative/--||BB/Negative/--||The termination of InterContinental Hotels Group PLC's operating agreement could increase Service Properties Trust's cash flow volatility, accentuate its tenant concentration and risks from related party interests, and lead to higher debt leverage in the near term, in our opinion. The negative outlook reflects our view that SVC's financial and operating performance will likely remain weak over the next 12 months as altered consumer behavior and social distancing measures related to the coronavirus pandemic continue to pressure its credit protection metrics.|
Washington Prime Group
|Samantha Stevens||Aug. 24, 2020||CCC/Negative/--||CCC+/Negative/--||WPG's covenant headroom and liquidity position continue to face substantial pressure due to the economic effects of the COVID-19 pandemic, which led to material cash flow volatility for the company in the second quarter because of rent deferrals/abatements and uncollectible revenue assessments following the temporary pandemic-related tenant closures. The negative outlook on WPG reflects our expectation that continued significant EBITDA declines could lead to a potential covenant breach in the next 12 months despite the recent amendments, which provide more cushion. We view the company's capital structure as unsustainable given its operating challenges due to the material acceleration in retail bankruptcies.|
Realty Income Corp.
|Fernanda Hernandez||Aug. 21, 2020||A-/Stable/A-2||A-/Stable/--||We assigned an 'A-2' short-term rating to Realty Income Corp.'s new $1 billion commercial paper program. We expect Realty Income to use it as a lower cost source of capital in lieu of normal borrowings under its revolving credit facility, not as an incremental source of debt. As of June 30, 2020, 48% of annualized rents were derived from investment-grade tenants, from which the company collected 100% of contractual rent due in July. In addition, Realty Income disclosed it collected 91.5% of cash rents in July. We consider this further demonstrates the resiliency of the portfolio. The outlook is stable and reflects our expectation that Realty Income's portfolio will continue to show above-peer-average resilience. Our stable outlook incorporates our expectation for the company to moderate its acquisitive growth strategy and to preserve liquidity, such that debt to EBITDA remains below 6x.|
Kimco Realty Corp.
|Kristina Koltunicki||Aug. 18, 2020||BBB+/Stable/--||BBB+/Stable/--||We affirmed all ratings on Kimco, including the 'BBB+' issuer credit rating. Kimco reported second-quarter earnings that were within our expectations and we anticipate it to maintain credit protection measures around current levels over the next 12-24 months despite near-term pressure on rent collection.|
Boston Properties Inc.
|Michael Souers||Aug. 3, 2020||BBB+/Stable/--||A-/Negative/--||Boston Properties' leverage has stayed elevated over the past couple of years, and we don't project material improvement to occur over the next two years. The stable outlook reflects our expectation that while the company's office properties should withstand pressure from the recession and social distancing measures relatively well, its retail properties and hotel will be materially impaired, resulting in adjusted debt to EBITDA rising to the high-7x area in 2020 before improving slightly in 2021.|
Vornado Realty Trust
|Fernanda Hernandez||Jun. 22, 2020||BBB/Negative/--||BBB/Stable/--||We expect the fallout from the economic recession will challenge re-leasing activity and constrain rent growth in Vornado Realty Trust's New York office portfolio and will pressure street-level retail across Midtown Manhattan amid mandated store closures to contain the spread of the coronavirus. Many of Vornado's retail tenants have suspended rent payments, and we expect this will drag on the company's performance through the remainder of the year.|
Dawn Acquisitions LLC
|Fernanda Hernandez||Jun. 12, 2020||B-/Negative/--||B/Negative/--||Dawn Acquisitions LLC reported weaker-than-expected operating performance for first-quarter 2020 and we believe that its revenue growth targets will continue to be hindered by the recession and that the timing for stabilizing profits is uncertain. As a result, we expect Dawn's debt to EBITDA to rise to 9x by year-end 2020, significantly higher than our prior forecast of 7.5x. The negative outlook reflects that we could lower our rating over the next 12 months if churn increases, resulting in further contracted revenue and cash flows such that we view the capital structure as unsustainable long term.|
Diversified Healthcare Trust
|Nicolas Villa||May. 29, 2020||BB/Stable/--||BB/Stable/--||We affirmed the 'BB' issuer credit rating on Diversified Healthcare Trust and assigned our 'BB+' issue-level and '2' recovery rating to its recent $1 billion unsecured senior notes issuance, which has subsidiary guarantees. We lowered the issue-level ratings on the company's existing unsecured senior notes to 'BB' from 'BB+' and revised our recovery ratings to '3' from '2' to reflect that the new guaranteed notes will have structural seniority with respect to those entities that guarantee it, over the existing unsecured senior notes and the existing unsecured credit facilities, both of which do not benefit from subsidiary guarantees.|
This report does not constitute a rating action.
|Primary Credit Analyst:||Ana Lai, CFA, New York (1) 212-438-6895;|
|Secondary Contacts:||Samantha L Stevens, New York + 1 (212) 438 1888;|
|Michael H Souers, New York (1) 212-438-2508;|
|Fernanda Hernandez, New York (1) 212-438-1347;|
|Kristina Koltunicki, New York (1) 212-438-7242;|
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