REITs at Risk for 'Correction' in Real Estate Markets
Some U.S. real estate investment trusts and real estate operating companies could face challenges if a correction were to happen in the "frothy" real estate investment and capital market areas, according to Moody's Investors Service.
Overall, the rating outlook for REITs and REOCs remains stable for 2005 and into 2006 as they sustain their moderate debt levels, stable-to-improving interest coverage, and sound liquidity - and as most commercial real estate property types continue to see their performance improve - the rating agency said.
"The top questions facing the industry are whether commercial real estate has peaked as regards to cap rates, and whether REIT stock prices and debt finance terms turn more hostile," notes Philip M. Kibel, a Moody's senior vice president and author of the report.
REITs and REOCs performed well during the recent economic downturn, thanks to low interest rates and "strengthening" capitalization rates on property sales, according to the rating agency.
As well, the "welcoming" capital markets and robust REIT stock performances of the 2001-2004 period helped REITs turn in a good showing.
The rating agency believes that REIT managements are to be credited for much of the good performance since they took measures to "refocus their growth strategies, sell non-core and underperforming assets, and reduce their development pipelines once they realized a recession was underway in 2001."
At the same time, "the moderate leverage and healthy levels of unencumbered assets that earmark many REITs were also of help" from a credit rating perspective.
At the end of 2004, leverage has remained stable in the sector, Moody's reports, with total debt-to-gross assets at about 44% at the end of 2004.
And their fixed-charge coverage, which Moody's defines as recurring EBITDA over interest expense and preferred dividends, has also stayed "relatively constant" at 2.5x.
As well, REITs have "retained strong liquidity positions and well-laddered debt maturities."
However, Moody's is concerned that many REITs are increasingly relying on growth generated through joint ventures, real estate fund structures, international investments, and merchant building and development businesses.
"The ultimate effects of these structures on REITs' transparency, strategic complexity, true leverage, liquidity and earnings stability can be negative," said John J. Kriz, managing director, Moody's real estate finance team.
"Firms that have increased their earnings by way of strategies such as real estate funds and joint ventures may find the costs outweighing the benefits."
The outlook for all the REIT sectors rated by Moody's is stable.
In the office sector, this outlook is supported by declining vacancies, rising employment and a limited supply of new space.
And Moody's believes that most office REITs have managed their balance sheets prudently.
The outlook for industrial REITs is "predicated upon expectation of moderate leverage, a large supply of unencumbered assets, and firming rental rates and occupancy."
Moody's expects most multifamily REITs to push harder for higher rents in 2005 and 2006. The sector is likely to see improving cash flows and reduced tenant concessions after a few years in which the increased affordability of the homeownership option combined with a falloff in employment negatively affected this sector.
The retail sector, which has a stable outlook, could be impacted by rising interest rates and energy prices.
Another rating agency, Fitch Ratings, expects rising interest rates to have an uneven impact on REITs, "disproportionately affecting companies depending upon their variable-rate debt exposure and their laddered-debt maturities."
The rating agency expects mall REITs to be "particularly vulnerable" to rising interest rates since they have higher levels of debt and "significant exposure" to variable-rate debt.
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