Strong RE Fundamentals Lead to Stable REIT Outlook for 2016

By Philip Kibel, Associate Managing Director, Moody’s Investors Service

With 2016 underway, Moody’s outlook for rated U.S. real estate investment trusts (REITs) and real estate operating companies (REOCs) is stable for each of the major underlying property sectors. The one exception is the multifamily sector, which has a positive ratings outlook. Real estate fundamentals continue to be strong across the various property sub-types, except for the suburban office sector, which remains challenged in certain markets. For third-quarter 2015, the majority of investment-grade-rated REITs reported solid core earnings growth, driven by continued rental rate increases and occupancy gains. With new supply at manageable levels across most submarkets, the fundamental outlook remains strong as we head into 2016.

Despite this earnings strength, many REITs’ financial profiles have deteriorated as a result of recent volatility in the debt and equity markets. The unsecured bond market remains available for REITs, although conditions have been choppy, with market access and pricing most attractive for those with strong business models and credit profiles. For other REITs, including those with more complexity and potential new issuers, new-issue concessions have been relatively steep, stemming the flow of debt issuance. As a result, many REITs are carrying more short-term debt and less excess liquidity as they await more stable market conditions.

At the same time, REIT equity prices have been choppy, owing to broader market concerns related to the global economy and rising interest rates. Because of this, many REITs are at the upper end of, or even above, their stated leverage targets.

The higher financial leverage is only temporary, however, and the financial position of these REITs will improve in the near term, using asset sales as an alternative means of generating liquidity and reducing leverage. The transaction market remains very strong, with prices for properties of varying quality trading at historically high levels. Thus, REITs can still readily dispose of their non-core, lesser-quality assets, using proceeds to pay down debt and fund other committed investments, including development pipelines.

Other key risks for REITs include potential excess new supply and macroeconomic shocks that could weaken real estate demand. Construction is picking up in some markets, particularly in the industrial, retail outlet, hotel and multifamily sectors. Some of this new supply is being built by the REITs, but private developers within certain subsectors are also becoming increasingly active for good projects in attractive markets. If this supply is being built to accommodate forecasted demand and if the already tenuous economic recovery were to reverse course, however, supply could outpace demand.