Fitch Ratings said Monday it would maintain a stable rating outlook for US equity REITs in 2017, thanks in part to the consistency with which the sector has adopted and maintained credit-friendly financial policies. Other factors weighing in REITs’ favor include expectations for good property fundamentals, consistent leverage profiles and access to attractively priced equity and unsecured bond capital. Furthermore, the ratings agency sees “better portfolio strategies and management, less risky external growth strategies and generally more conservative financial policies” underpinning a positive outlook for the sector.
From the standpoint of fundamentals, Fitch says it expects multifamily to lead the way once more, although same-store NOI growth will be below 2016 levels, and some markets are likely to post negative results. Most retail, industrial and office REITs should have positive SSNOI growth next year, says Fitch.
“Companies are increasingly focusing on (re)development to drive earnings in the context of a competitive acquisition market, lower leverage and modest organic growth,” according to Fitch’s equity REIT outlook report. Good property fundamentals may cause some companies to moderately increase their appetites for speculative development, particularly industrial REITs.” Such later-cycle development, in Fitch’s view, poses “execution and funding risks.”
Fitch anticipates that issuers will retain access to low all-in-cost secured and unsecured debt, despite expectations of increasing short-term interest rates—starting, most likely, with a move by the Federal Reserve later this month. The ratings agency notes that the property transaction market remains “robust,” thereby enabling companies to fund leverage-neutral growth initiatives and improve portfolio quality via asset sales.
US REIT leverage isn’t expected to change meaningfully next year, according to Fitch. “Proceeds from dispositions will be redeployed toward acquisitions, development or modest share repurchases, and equity issuance will be episodic,” the report states. “Any deleveraging will be organic as companies grow recurring operating EBITDA and retain cash flow.”
At present, the REIT sector has more borrowing exposure from commercial banks than previously, on account of banks providing issuers with a surrogate to unsecured bond offerings in the form of long-tenor, low-cost term loans, with the added benefit of no prepayment penalties, save for swap breakage costs. “Issuers have not termed out bank funding via the bond market, which is surprising given the strength of unsecured bond markets over the last five years; this exposure could limit liquidity via commercial banking relationships should they need incremental bank funding,” Fitch says.
The average REIT trades at a 7% discount to net asset value, according to Fitch. The discount on NAV puts pressure on companies to fund external investments on a leverage-neutral basis should they choose to do so. Further, certain companies trade at deep NAV discounts and/or multiples well below their peer set.
While the “stable” rating outlook is carrying through into next year, Fitch says the outlook could be revised to positive if sector-wide leverage is sustained below 6.5x; currently it’s at 6.4x. “Sustained job growth, improving fixed-charge coverage and continued strong capital markets access and liquidity” would be macroeconomic factors driving an upward revision.
Conversely, Fitch says the rating outlook for REITs could be revised to negative if current REIT metrics take a turn. Among these: development exposures approaching prior peak levels, access to long-term unsecured debt capital weakening, leverage increasing meaningfully, lower coverage levels occurring, property-level fundamentals weakening and issuers embracing equity-friendly strategies, such as speculative development to drive growth or share buybacks.
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