REITs face challenging operations conditions amid higher interest rates and slower economic growth.   Although operating performance largely met our expectations in the fourth quarter of 2022, we expect slower growth ahead across all property types. (Although, industrials and residential REITs will likely remain more resilient with better near-term growth prospects.) Operating performance at retail REITs has largely returned to pre-pandemic levels with stable occupancy and positive rent spreads, though weaker consumer spending and inflation could pressure tenants. The office REITs remain a sector of focus given longer-term secular headwinds from remote working and near-term cyclical risk from a weaker economic outlook. For 2023, we expect low- to mid-single-digit growth for most property types with the exceptions of office and industrials. For office REITs, we think both net effective rents and occupancy could be pressured, leading to flat or slightly negative same-property net operating income (NOI) growth. The office sector also has relatively higher debt leverage given development exposure which adds to the downside risk. For industrials, a strong mark-to-market opportunity and stable occupancy should drive high-single-digit same-property NOI growth.

The pace of negative rating activity has picked up momentum in 2023, with four downgrades to one upgrade so far. We lowered the ratings on Medical Properties Trust Inc. (BB+/Stable/--), Kennedy-Wilson Holdings Inc.(BB/Negative/--), Diversified Healthcare Trust (CCC+/Negative/--), and Forest City Realty Trust Inc. (B/Negative/--) and we upgraded W. P. Carey Inc. (BBB+/Stable/--) and Invitation Homes Inc. (BBB/Stable--). We expect the negative rating bias to increase in 2023, with office REITs likely facing more negative rating actions given their more limited cushion in credit metrics relative to their downgrade triggers. About 9% of ratings have negative outlooks while 89% are stable and 2% are positive (Chart 1).

Capital access has improved somewhat with numerous debt issuances in the first quarter, although the volume is still lower year over year. However, we expect access to capital, particularly for low-investment-grade or speculative-grade credits, to remain constrained given higher interest rates and growing valuation pressure. We expect higher borrowing costs to pressure credit metrics, narrowing issuers' cushion under fixed charge coverage ratios. We also expect equity issuance to remain modest as most REITs are trading at a significant discount to net asset value (NAV). Despite these tightening market conditions, we believe the vast majority of REITs have manageable debt maturity profiles and relatively modest exposure to variable rate debt. However, issuers with significant near-term debt maturities could face tighter and more expensive financing conditions, with refinancing options likely including secured funding, given the volatility in the bond market.

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Sharp increases in mortgage rates are likely to pressure homebuilders' revenue and profits.   The homebuilder sector is facing a significant decline in revenue and profitability in 2023 after two years of strong performance. We expect a significant drop in revenue and profits for the homebuilders in 2023. We expect revenue pressure given lower orders, higher cancellation rates, and lower selling prices as demand drops from consumers adjusting to the new mortgage rate levels and higher monthly mortgage payments. Builders reported higher cancellations and lower orders in the fourth quarter as consumers paused home purchases. The 30-year mortgage rate climbed to levels not seen since 2008, reaching over 7% at the end of 2022 and we expect the rate to stay above 6% in 2023. Mortgage rates have essentially doubled since 2021, resulting in the lowest housing affordability for a generation of Americans who have grown accustomed to mortgage rates that were about 300 basis points lower. We expect higher incentives (rates buydown, lower selling prices) to put significant pressure on margins, reversing a period of strong performance and reverting toward more normalized margin levels in 2023.

Although we are getting better visibility to the outlook in 2023, there is still quite a bit of uncertainty regarding homebuilders' performance given the potential for further rate hikes. We expect revenue declines of 20%-30% and EBITDA contraction of 25%-30% for the rated homebuilders, but the performance of each issuer could differ based on market, customer, and product focus. Elevated mortgage rates could dampen demand into 2024, extending the downturn. Despite our expectations for a significant decline in 2023 EBITDA, builders have increased their cash balances and reduced debt, resulting in significant cushion over downgrade triggers. Reduced working capital as builders pull back on land spend could also become a source of cash supporting financial flexibility.

The positive rating bias for homebuilders has moderated with several revisions of outlooks from positive to stable or negative. We currently have about 30% of ratings with positive outlook while the portion of ratings with negative outlook rose to 17% (Chart 3). We revised the outlook of Weekley Homes LLC (BB-/Stable/--) to stable from positive given our expectations for sharply lower profitability in 2023, pressuring credit metrics. We also revised the outlook on Empire Communities Corp. (B-/Negative/--) given deteriorating liquidity as its revolving credit facility is current, due December 2023.

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We expect modest declines in revenue and narrowing profit margins for building materials issuers as the ability to pass on costs diminishes through the year and input costs remain elevated.   While 2022 operating results benefited from order backlogs and companies' ability to raise prices, we expect volume declines in 2023 given a weaker housing market and declining spending on renovations and remodels. As a result, in 2023 we expect modest declines in revenue (about 5%-10%) and narrowing profit margins with EBITDA declining in the 10%-15% range. Although we continue to believe that repair and remodeling end markets are more stable than new construction, we believe there will be declines in repair and remodeling in 2023 given lower consumer confidence and higher consumer costs. We think potential declines could be mitigated by homeowners focus on improving their existing homes as they are priced out of new ones. The performance of each building materials issuer will vary based on end markets and product exposure. Given expectations for an increase in nonresidential spending from investments in infrastructure, this could temper some of the declines in the cyclical residential end market. Indeed, we think issuers with exposure to the aggregates segment will remain more resilient compared to those exposed to discretionary products and new home construction. Reduced investments in working capital (from slower conditions and deflating commodity costs) would provide some support for better free cash flow generation and liquidity.

For building materials issuers, we currently have about 94% of ratings on stable outlook, 5% on negative and 1% on positive (Chart 4). Most issuers are rated in 'B' category given the high level of private equity ownership, and we expect lower- rated issuers with upcoming debt maturities to face growing refinancing risk. Still, building materials issuers are coming off a strong year in 2022 given the benefit of healthy backlogs and pricing realization. Issuers operating with limited cushions to credits metrics under the downgrade scenarios or facing significant debt maturities could face heightened ratings pressure. As such, a shift toward a more negative outlook bias could arise in 2023, as the prolonged effect of inflation and elevated interest rates reduce consumer discretionary spending and pressure. We recently revised the outlook on Stanley Black & Decker Inc. (A/Negative/--) to negative given weaker earnings and deteriorating credit metrics. We also lowered the ratings on Werner FinCo L.P. (CCC+/Negative/--) to CCC+ with a negative outlook given weakened financial performance, upcoming debt maturities and elevated debt leverage. On the flipside, we upgraded Smyrna Ready Mix Concrete (BB-/Stable/--) to 'BB-' with a stable outlook given its profitable and material expansion in scale and geographic diversity while maintaining stable profit margins.

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