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Real Estate Monitor: Negative Rating Bias Grows In The U.S. Real Estate Sector

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Real Estate Monitor: Negative Rating Bias Grows In The U.S. Real Estate Sector

Homebuilders' positive rating momentum is decreasing

Second quarter results showed a deceleration in operating momentum from the homebuilders rated by S&P Global Ratings. We believe the sector has reached peak gross margins and expect them to decline over the next several quarters, given slowing housing demand, an increase in cancellation rates, and persistent cost pressure from supply chain issues. Lately builders have been offering more incentives (from almost no incentives a year ago), such as a reduction in the sale price of the homes, pressuring profitability. Some builders have pulled financial guidance for fiscal 2022 given sharply higher mortgages rates and a weaker economic outlook. We are also seeing an uptick in cancellations as consumers reconsider their home purchases, and expect builders to slow orders given weaker demand amid supply chain constraints.

Given these headwinds, we expect our positive ratings bias for the homebuilders to moderate over the next year. We recently revised the outlook on LGI Homes Inc. to stable from positive as we expect their revenue and EBITDA to decline because of longer construction and development cycles and delayed home closings. We also revised the outlook to negative for both Brookfield Residential Properties Inc. and The Howard Hughes Corp. due to difficulty forecasting cash flows and underperforming key operating assets. The portion of ratings on positive outlook has declined from about 40% to 33% in the last quarter.

The 30-year mortgage rate has climbed to record levels since 2008, reaching above 6% as of Sept 14, 2022. This has worsened housing affordability for a generation of Americans who have grown accustomed to rates that are 200 basis points lower. According to S&P Global economists, housing affordability is the weakest it's been since 2006. Our affordability measure of mortgage payments as a share of income, assuming a 10% down payment, likely topped 25% in second-quarter 2022 for the typical first-time buyer and is set to worsen to 28% by fourth-quarter 2022--its highest since first-quarter 2007 during the financial crisis--on soaring home prices and mortgage rates, particularly for first-time home buyers (see "The American Dream May No Longer Be In Reach," published July 20, 2022).

To address affordability concerns, builders have been offering price discounts on individual homes, optional upgrades (to appliances, cabinetry, and flooring, for example) without charge, and financing incentives, such as mortgage interest rate locks and buydowns to its buyers. These incentives are meant to help the builder close on the home in the face of higher cancellation rates.

Despite the rapid slowdown in housing demand, rated homebuilders are coming off a period of strong performance and peak gross margins. While we expect profitability to start trending back towards more normalized levels, most homebuilders have improved their balance sheets and are operating with significant cushion relative to our rating downgrade triggers. Builders are adjusting to weaker demand by slowing their starts and land acquisitions, to preserve cash. They are also adjusting their pricing to get the appropriate number of deliveries.

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Building materials sector is also under pressure

While second quarter results for rated building materials issuers were mostly positive given order backlogs, we expect slowing revenue growth for the building materials sector over the next year. Demand for building materials is cyclical and an expected housing cool-down will pressure demand for materials used in remodels and renovations. We expect housing starts to decline to 1.5 million in 2023 from 1.6 million in 2022 as the impact of higher mortgage rates take hold. In addition, weaker consumer confidence driven by inflationary pressure can also reduce spending on repairs and remodels. Our economists currently estimate the risk of a recession at 45% in the U.S. as economic momentum continued to worsen in recent months. High housing prices and rising interest rates hurt affordability and slowed domestic activity in recent months, which will likely worsen into 2023. As demand softens, the ability to pass on cost increases will likely diminish, resulting in growing margin pressure.

Issuers with operations in Europe could also face energy cost pressure and macro headwinds. As Europe faces continuing uncertainty about the war in Ukraine and Russia tightens the noose on natural gas, higher natural gas prices could further dampen margins. Germany and Italy are most exposed given their heavy reliance on Russian gas (see "Europe Braces For a Bleak Winter," Aug. 29, 2022). Among the rated portfolio, Mohawk Industries Inc. and Jeld-Wen Inc. generate about 28% of their revenue from Europe.

Building materials issuers have already started to feel the squeeze from cost inflation in 2022 with some reported lower margins in the first half of 2022 from supply chain issues stemming from the pandemic. Despite expectations for weaker performance, we're seeing a moderation in input costs with oil and commodities prices already declining from peak levels, which could help mitigate revenue pressure in the next few quarters. In addition, we expect the commercial end market to remain more resilient despite a softening in the residential end market.

As spending slows and cost pressure persists, we think building material issuers more exposed to new construction and discretionary general materials to face more pressure than those exposed to aggregates and non-discretionary general materials (i.e. roofing, HVAC) or infrastructure and commercial end markets. In particular, aggregates companies could benefit in coming years from spending related to the country's $1.2 trillion Infrastructure Investment and Jobs Act.

Currently, 88% of ratings have stable outlooks. We recently affirmed the ratings on Mannington Mills Inc. and maintained a stable outlook as we expect credit metrics to remain in line with the rating despite our expectations for slower revenue growth. We also recently assigned our 'A-2' to Vulcan Materials' new $1.6 billion commercial paper program. We lowered the ratings on Cornerstone Building Brands Inc. following the leveraged buyout by Clayton Dubilier & Rice, given our expectation for leverage to rise towards the 6x-7x range in the next year.

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REITs' revenue growth will slow

While overall operating results for rated REITs in the second quarter were mostly positive, we expect slowing revenue growth in the next few quarters as consumer spending weakens and the impact of interest rate hikes take hold. We think retail REITs could see some pressure from tenants holding bloated inventory levels amid weaker consumer demand. This could result in a deterioration of retail tenant quality and a growing watch list after a period of stabilization. For the office sector, we expect a slow pace in employees returning to office and a deteriorating job market to dampen demand for office real estate over the next year. We revised the outlook on Office Properties Income Trust to negative given its elevated debt leverage and increased execution risk related to the company's proposed asset sales. Currently 85% of ratings have stable outlooks, with the remainder split between positive and negative outlooks.

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On the flipside, we expect industrials and rental housing REITs to remain resilient and we took a number of positive rating actions in recent months. We upgraded Prologis Inc. to 'A' from 'A-' given or expectations for strong operating performance amid favorable tailwinds for industrial assets and significant mark-to-market rent spread potential despite a slowing economic outlook. We also upgraded Mid-America Apartment Communities Inc. to 'A-' from 'BBB+' given its track record of above-average NOI growth, low debt leverage, and a conservative financial policy.

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Debt issuance by equity REITs remained subdued through August 2022 given rising rates, market volatility and limited refinancing needs. Capital raising activity slowed significantly in 2022, with equity REITs raising 72% less in capital compared to a year ago and we don't expect the market to pick up in the near term. REITs equity prices have also come under pressure. Publicly listed U.S. equity REITs traded at a median 19.1% discount to their consensus S&P Capital IQ net asset value per-share estimates as of the end of August, a further decline from the 12.9% discount at which they traded as of July.

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Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Ana Lai, CFA, New York + 1 (212) 438 6895;
Secondary Contacts:Maurice S Austin, New York + 1 (212) 438 2077;
William R Ferara, Princeton + 1 (212) 438 1776;
Kristina Koltunicki, Princeton + 1 (212) 438 7242;
Michael H Souers, Princeton + 1 (212) 438 2508;

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