How High Inflation Could Impact REITs

Performance for these companies in the coming year hinges largely on the duration and severity of rising prices, notes Stephen Boyd of Fitch Ratings.

Stephen Boyd

News of inflation has been everywhere, especially after the Labor Department announced earlier this month that the U.S. had experienced its largest price surge in over 30 years during the month of October. No one knows for certain how long high inflation will last, but the latest estimate from the Federal Reserve projects it could take well into 2022 before prices and interest rates stabilize.    

The question of inflation’s impact on REITs will largely depend on the length of time it takes to steady rising interest rates—as well as how high the rates get. If inflation and higher rates remain a temporary issue, U.S. equity REIT credit profiles are unlikely to suffer any significant impact, causing minimal disruption.

A prolonged period of inflation and rapidly rising interest rates, however, could negatively affect cash flows, lower property values, and create a more difficult refinancing environment due to higher cap rates. This could also stress covenant compliance cushion if debt ratios are based on asset values.

In past periods of extreme inflation, the REIT sector was smaller and less diversified, consisting primarily of mortgage REITs rather than property owners. As a result, its resistance has not been tested in the surging interest rate environment we are currently experiencing. The effects of higher interest expenses will likely depend on the property type, with capital structure, portfolio lease tenor, and other considerations dictating the credit implications for individual issuers.

Financial performance in this higher interest rate environment will be supported by conservative debt levels and moderate exposure to short-term and variable-rate debt. Longer-weighted average debt maturities will also support performance, though an unbalanced debt maturity ladder could lead to refinancing shocks in a given year.

In terms of liability duration, it’s best viewed in the context of portfolio lease tenor. Long-term leases provide less immediate opportunity to raise rents to offset rising costs. Conversely, REITs that own operationally intensive property types with shorter lease durations are better able to handle a potential spike in interest rates, due to the ability to quickly mark leases to market.

If inflation remains a short-lived issue, REITs are likely to maintain solid footing. But as we approach the end of the year and interest rates remain elevated, it will be important to watch inflation’s trajectory and the potential impact it will have on REITs in 2022 and beyond.  

Stephen Boyd is senior director, U.S. Real Estate and Leisure, at Fitch Ratings.

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