- Rating bias among the U.S. REITS we rate remains negative.
- The subsectors with the greatest downside risk are retail REITs (as the number of distressed tenants remains high) and office REITs (many tenants are considering reducing the amount of space they occupy).
- Industrial assets have continued to perform well.
- Despite pandemic-related stress, REITs have maintained solid liquidity and are on pace to issue a record amount of debt.
We expect a choppy recovery in the U.S. REIT sector in 2021, as fundamentals will likely remain pressured over the next few quarters. While third-quarter operating results show signs of recovery, with a sequential improvement in rent collection, we believe the recent spike in COVID-19 cases could result in increased restrictions for non-essential businesses. This could lead to weaker consumer spending and job growth and dampen real estate demand going into 2021. Despite the recent recovery in unemployment to 6.9% in October, there are still 21 million people receiving unemployment benefits in the U.S., and S&P Global economists don't expect unemployment to return to pre-pandemic levels until mid-2024.
Rent collections appear to have stabilized in the third quarter following a sharp decrease in the second quarter. The trends were particularly encouraging for retail landlords, as the majority of retail tenants have reopened after the initial severe lockdowns in March and April. In addition, landlords have already negotiated most of the deferrals for those periods, and we expect future abatements to subside from second-quarter levels. Still, we believe there's limited potential for rent collections to improve much further from third-quarter levels until a vaccine contains the pandemic.
We expect the impact from COVID-19 to persist well into 2021, which means the risk of additional tenant bankruptcies will also remain elevated. Retail, leisure, and senior housing assets remain challenged, while there's been increased pressure in rental housing REITs exposed to urban markets. We also believe there is growing risk for office demand to drop, as work-from-home trends will likely continue into 2021 and beyond. Industrial and data center assets remain well-positioned to outperform other property types given the benefits of strengthening supply chains and remote working. Assuming an effective vaccine is widely distributed, we expect the net operating income (NOI) of the subsectors most significantly affected to stabilize toward the second half of 2021.
We view the U.S. elections as largely neutral for our rated REITs. At this point, we don't expect any policies under the new administration to have a material impact on the credit quality of U.S. REITs. Further stimulus could support an economic recovery, while regulatory policies affecting tenant protection, 1031 exchanges, and higher taxes could have some negative impact.
Favorable COVID-19 vaccine news provides better visibility to recovery, particularly for the second half of 2021. Recent news on the timing and effectiveness of vaccines is promising. Our economic forecast and sector base case include an assumption that the vaccine will be widely available by mid-2021. This would remove a key source of uncertainty hanging over consumption and investments, supporting steady economic recovery in the second half and driving stronger demand for real estate assets.
The COVID-19 pandemic has accelerated secular changes directly affecting real estate demand. We expect a multi-year recovery for U.S. REITs, with credit metrics largely returning to pre-pandemic levels by year-end 2022. Ultimately, the recovery of real estate demand will depend on any changes to consumer behavior post-pandemic, which are not yet clear.
Suburban markets should perform more strongly than urban ones in the near term due to the urban exodus. Densely populated markets will likely underperform suburban areas as extended working from home allows residents to seek larger living spaces outside of urban areas. For residential rental REITs, we expect urban markets such as New York and San Francisco to underperform Sun Belt markets. In the third quarter, occupancy for urban apartments was several percentage points lower than their suburban counterparts within the same markets. We expect this gap to remain until workers return to offices in these gateway markets, which likely won't happen until a vaccine is widely available. As such, we expect urban areas to face NOI pressure as occupancy drops and concessions increase, while suburban locations should have more stable performance.
We believe residential REITs could face modest operating pressure over the next year, with NOI declines in the low- to mid-single-digit percent range and some deterioration in credit metrics due to lower rents and occupancy pressure. Still, we generally expect rating stability among our rated residential REITs, with strong balance sheets and sufficient liquidity to weather the headwinds created by the pandemic. The desire for more space will continue to drive demand for suburban and single-family rental assets. To illustrate: In the third quarter, solid leasing momentum drove American Homes 4 Rent's (BBB-/Stable/--) same-home portfolio occupancy to 96.9%, with 5.9% growth in new leases.
Retail REITs' operating performance is stabilizing but still faces significant tenant risks. Retail REITs have been one of the sectors most affected by the pandemic, but there is a divergence in performance between malls and strip centers. We expect the performance of malls, with their high portion of discretionary merchandising, to underperform strip centers, which are generally anchored by grocers and big-box stores that offer largely nondiscretionary merchandise.
While rent collections improved significantly in the third quarter following a steep decline in the second, overall rent collections remain in the 80%-90% range. Moreover, we believe there's limited upside to that rate, as restrictions are being reinstated and consumers remain apprehensive about visiting non-essential retail and small shops. Retail REITs have managed the growth of e-commerce by diversifying their tenant bases toward more experiential offerings such as restaurants and movie theaters, but this same tenant base has been most significantly disrupted by COVID-19.
Regional malls have been severely affected by the sudden drop in cash flow due to COVID-19-associated rent deferrals. We lowered our ratings on Washington Prime Group Inc. (WPG) to 'CCC' in August 2020 and subsequently to 'CC' in November due to the active debt negotiations with its creditors, which could result in a distressed exchange. Regional mall owners CBL & Associates and Penn REIT (both unrated) recently filed for bankruptcy, and major tenants such as JC Penney have also filed for bankruptcy protection.
For strip centers, small business closures are also rising, and significant concessions have been granted to keep viable small shops operating in the near term. A higher-than-expected failure rate among small businesses could result in greater occupancy pressure in 2021. Some REITs have moved their more vulnerable tenants--such as small shops--to cash-basis accounting. For example, about 24% of Regency's ABR is on a cash basis, of which 70% comes from small shops.
We expect ongoing operating pressure for retail REITs in 2021, as tenant risk remans high, with the potential for more bankruptcies and store closings. The full collectability of deferred rent also remains uncertain, and we expect some write-offs in the coming quarters.
There is growing risk for office REITs in gateway markets; the slow return to offices will keep utilization low, and many tenants are considering downsizing their footprints. Rent collections by office REITs remain high (in the mid- to high-90% area), even as offices sat virtually vacant for months. Declining NOI has mainly stemmed from non-office rent, such as parking and retail revenue. However, the current data could be masking the secular headwinds the sector is facing. A more permanent adoption of remote working could lower the demand for office space. Indeed, many corporate tenants are re-evaluating their optimal footprints, which could result in them reducing their space at renewal. Moreover, subleasing activity has already picked up, and rental concessions (free months and tenant improvements) are rising. Still, given the staggered lease maturities for office REITs, we expect the deterioration will take some time.
We expect office REITs to face weak leasing activity as tenants consider downsizing their office footprints, and we anticipate modest declines in NOI in 2021 from lower occupancy and rent prices. We expect gateway markets such as New York and San Francisco to underperform suburban markets given the slow return to the office due to complexities with public transportation and elevator usage. Suburban offices should face less pressure than dense urban markets over the near term, with more resilient occupancy rates and more stable rent. Development exposure and potential delays in lease-up could also delay improvements to key credit metrics.
Despite the downside risks for traditional office REITs, demand for life sciences should remain resilient given the continued growth in biotechnology and pharmaceuticals, buoyed by scientific advancements and strong capital flows.
Health care REITs' senior housing assets will continue to face cash-flow volatility. Within health care portfolios, senior housing operating property (SHOP) assets have been most vulnerable to cash-flow pressure. This is because the pace of move-ins has slowed significantly given shelter-in-place mandates and self-imposed restrictions to ensure residents' health and safety. This resulted in significant year-over-year occupancy declines in recent quarters. In the third quarter, this occupancy drop--along with higher labor costs and personal protective equipment expenses--drove a 42.2% same-property NOI decline in Ventas's SHOP portfolio and a 27.3% decline in Welltower's. Both Welltower (BBB+/Negative/A-2) and Ventas (BBB+/Negative/A-2) have significant exposure to SHOP assets. In the same quarter, Ventas generated 28% of its NOI from SHOP assets, and Welltower generated 37%.
While new resident cases are substantially lower than they were at the peak of the pandemic in April, we expect further pressure on operating metrics for the remainder of the year and into the first half of 2021 until a vaccine is widely available. We believe that an effective vaccine could drive a recovery in occupancy in late 2021, but health care REITs might need to offer some level of discounting to drive demand. One extremely positive recent development for the sector is that assisted living facilities (ALFs) are now eligible for government aid. All ALFs (and campuses that have any exposure to ALFs) are scheduled to receive 2% of 2019 revenues from the Department of Health and Human Services (HHS) in the fourth quarter or in first-quarter 2021. Moreover, operators were eligible to apply for additional funding to offset the impacts of the pandemic. While it is uncertain how much additional assistance HHS will provide, it could be material.
Industrial assets continue to perform well during the pandemic despite some initial impact on operating performance earlier in the year. In the third quarter, transaction volume significantly improved across most property types, including industrials, which showed solid improvement from the second quarter. According to Prologis Inc. (A-/Stable/--), net absorptions for 2020 are now anticipated to be 210 million square feet, while completions are expected to be 295 million square feet; each of these figures is about 50 million higher than the prior estimate. The tenant segments accounting for the new leasing are essential industries, including food and beverage, health care, consumer products, and ecommerce. Rent collections and lease rollover generally remain strong for the subsector, as tenants continue to improve their supply chains.
REITs have maintained solid liquidity and are on pace to issue record debt despite the pandemic. Despite operating headwinds in 2021, REITs maintain solid liquidity and good access to debt capital markets given most are rated investment grade. U.S. REITs' debt issuance has remained robust throughout 2020, with $66 billion of senior unsecured debt as of October, and it could surpass the record set last year. REITs have also been active in the green bond market, with several issuances in 2020. Among those, Federal Realty issued its inaugural green bond. However, equity issuance remains significantly below 2019, as many REITs are trading well below consensus NAV estimates. As operating conditions stabilize in 2021, we expect some REITs to reinstate dividend payments after dividend cuts or suspensions in the second quarter.
Rating bias remains negative, with greater downside risk for retail and office REITs. While we expect credit metrics to recover from the depressed 2020 figures, they will likely remain toward the weaker end for the respective ratings given the slow expected recovery. Nevertheless, we believe REITs will maintain relatively conservative financial policies as they navigate this downturn, with a focus on preserving liquidity. Indeed, many REITs have cut or suspended dividends, cut costs, and reduced capital spending or development activity to preserve cash. We believe most REITs have good liquidity, with adequate cash, revolver availability, or access to capital to withstand near-term pressure. Moreover, we believe REITs entered this recession in better shape than in the last, given their lower leverage, larger pools of unencumbered assets, and well-laddered debt-maturity profiles, all of which should help mitigate downside risks.
This report does not constitute a rating action.
|Primary Credit Analyst:||Ana Lai, CFA, New York + 1 (212) 438 6895;|
|Secondary Contacts:||Kristina Koltunicki, New York + 1 (212) 438 7242;|
|Michael H Souers, New York + 1 (212) 438 2508;|
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