Emboldened by Recovery, REITs Expand Again

Stephen Boyd

2022 is off to a fast start, with the surging Omicron variant giving the U.S. little respite from ongoing COVID-related economic challenges. Looking at what’s in store for REITs in the year ahead, the sector is improving across the board for all property types. The recovery is occurring at varied rates, with some sectors facing unresolved risks from pandemic-related behavioral patterns.  

So far, during the pandemic, REIT credit profiles have experienced minimal sustained deterioration in credit risk and ratings, aided by strong balance sheets, healthy capital access, and stable or swiftly rebounding property net operating outcome. Leverage for the sector jumped higher during the first year of the pandemic, but from a low base to fairly manageable levels.

Now, with property fundamentals steadily improving, some REITs are adopting more aggressive portfolio expansion strategies, capitalizing on healthy sector credit profiles, attractively priced capital and strong pricing for noncore asset sales.

Consumer-driven sectors, such as retail and residential, should benefit from healthy spending trends. Industrial REITs also remain a bright spot, achieving positive growth through the pandemic on the back of strong e-commerce demand. Income growth for some specialty property types, such as data centers and cell towers, continues unabated.

The recovery for property types that rely on commercial tenants—such as hotels and offices—will remain under pressure from subdued corporate demand, especially in the first half of the year, as travel plans remain halted and many businesses continue to work remotely. 

Risks for REITs

While the majority of property sectors are experiencing improving demand trends, there are still key risks to keep an eye on. New and more transmissible variants have the potential to delay recovery, further clouding the medium- to long-term outlooks for office and enclosed retail properties.

Transitory inflation could also be a potentially disrupting factor for REIT credit profiles. Though it currently poses minimal risk to most REITs, prolonged inflation would present more of a notable challenge, pressuring credit profiles and potentially reducing property values. Longer duration property formats, including office, retail, and triple-net lease REITs are most at risk under such a scenario.

Sector debt as a percent of gross assets has remained relatively unchanged throughout the pandemic, suggesting issuers did not capitalize operating losses. It’s likely that leverage will return to pre-pandemic levels during the second half the year, as cash flows rebound.

That being said, pro-cyclical posturing and the likelihood of higher interest rates could have some REITs temporarily testing the upper bounds of financial policy targets, particularly in sectors that lack access to attractively priced equity. REITs that are out of favor with equity investors, such as office and some retail REITs, are most at risk of accelerating debt issuance or adopting riskier external investment postures.

Ratings remain concentrated in the ‘BBB’ investment-grade category, reflecting generally stable rental income and liquidity from CRE assets. Fitch expects more rating outlook changes to Stable from Negative for REIT issuers, assuming rating case economic and financial projections are met.   

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