These REIT Sectors Face Slower Growth

Chris Wimmer

2023 is expected to be a challenging year both economically and financially for virtually every sector, including REITs. Fitch anticipates a mild recession in the year ahead, which will likely be in line with current difficult economic trends, including increasing interest rates, inflation, and reverberation from the war in Ukraine. For the REIT sector, these economic hurdles have resulted in higher capital costs, wider bid-ask spreads in cap rates, and increased uncertainty in both capital markets and commercial property transactions.

Though conditions had generally been improving as pandemic restrictions eased, Fitch now expects slower growth for REIT sectors that had been experiencing solid demand, including industrial and open-air shopping, and more difficult conditions for others that have been challenging, such as offices.

Shining Stars to Decelerate

Industrial REITs, consisting primarily of warehouse and distribution facilities, have been one of the best performing sectors since before the pandemic. As e-commerce’s popularity skyrocketed during the past few years, industrial’s strength accelerated even further. Businesses, especially retailers, were forced to pivot from in-store sales to deliveries from industrial facilities, spurring strong demand for the sector that continued into 2022. In 2023, Fitch believes demand will moderate and leasing will slow amid a recessionary environment. As a result, industrial tenants will find further incremental gains in e-commerce more difficult to achieve.

After encountering hiccups during the pandemic, retail open-air shopping center REITs demonstrated the stability of the necessity-driven model. These REITs are typically anchored by a grocery store or pharmacy, and experience solid fundamentals and earnings. Fitch expects meaningfully less tenant distress than early in the pandemic, as many weaker retailers have already been forced to close their businesses, replaced by relatively stronger ones.

Offices Face Increased Pressure

For office REITs and their tenants, the question of space utilization remains key. While headline numbers for office jobs have generally strengthened, data for employees actually in-office has been notably less robust. A weaker economy in 2023 could convince an increased number of tenants to opt for less space on margin, creating further challenges for office landlords.

Evidence for this is already beginning to emerge as development projects are paused or shelved– indications that office REIT dividend cuts are on the horizon. Office markets are likely to face increasing pressure due to recent layoffs, particularly in the tech sector. As the tech industry has expanded beyond its former geographic limitation of the West Coast, offices in regional markets across the country may feel this pinch.

Distressed Opportunities

This year, REITs will also likely find tenants shelving expansion plans or taking longer to make leasing decisions. While most REITs rated by Fitch have the capacity to withstand such a slowdown, smaller-scale developers that lack balance sheets and liquidity will be forced to dispose of their projects–likely at distressed prices. REITs that maintain ample dry powder will find distressed opportunities when developers are unable to finance projects to completion or place recessionary-wary tenants, especially for properties built on speculation.

Chris Wimmer, CFA, is senior director, Fitch Ratings.