Capital Scarcity and Falling Real Estate Values High on REITs’ Risk Radar

June 2017

After the Federal Reserve kicked off its long-awaited rates hike program in December 2016, REITs are bracing for the impact of multiple interest rate increases and evaluating their ability to effectively hedge their debt. 

Higher costs of debt and equity could also strain retailers and other tenants that have benefited from the low interest rate environment and the availability of cheaper debt. Nearly all REITs (98 percent) cite interest rate increases—and their ability to hedge against them—as a risk to their strategies this year. Uncertainties over inflation are also on the rise this year, with 52 percent of REITs listing it as a risk to their business in the year ahead, up from 42 percent in 2016.

Inflationary pressure and interest rate worries are likely being driven by growing concerns about tightening capital markets and potential declines in real estate values and lease rates across several REIT sectors. The top 100 REITs unanimously cite access to capital, financing and liquidity as a risk to their business, up from 96 percent in 2016 and 93 percent in 2014. This year also saw a meaningful jump in the number of REITs (86 percent) that listed bankruptcy and foreclosure as a risk this year, up from 80 percent in 2016, and 37 percent in 2012. 

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Worries about credit risk is also growing among the top 100 REITs. Most (86 percent) cite credit risk, which represents a meaningful jump from 55 percent in 2014 and 38 percent in 2013. Financing and transactional concerns among REITs appear to be reflected in the broader commercial real estate market, which is showing signs of further slowing in 2017 after several bull-market years. According to a recent report by Scotsman Guide, the industry saw a 31 percent drop in deal activity between February 2016 and 2017. That followed double-digit year-over-year declines in both December and January as well.


Macro-Level Economic Tightening Exacerbates Sector-Specific REIT Challenges

As the economy begins to show signs of uncertainty at the macro-level, several REIT sectors are facing a unique set of challenges for growing their business on a micro-level. For example, among residential REITs, 83 percent worry tenants could be unable to pay rent and 100 percent list falling rental rates as a top concern. It’s notable that increased worries over tenant solvency is consistent across all REIT sectors this year, whether commercial or residential. Four out of five REITs (80 percent) cite tenants being unable to pay rent as a risk to their business in 2017, up from 71 percent in 2012. Furthermore, nearly all (96 percent) REITs say their business faces risks related to indebtedness this year, up from 75 percent in 2014.

Retail REITs, however, are facing the biggest economic challenges, largely due to the rise of e-commerce. Retail REITs face even bigger challenges as both malls and brick-and-mortar retailers are seeing significant cuts to consumer demand and asset valuation. Among retail REITs, 96 percent cited their tenants’ ability to pay rent as a risk in 2017, while 72 percent said the loss of an anchor tenant was a risk for their business.

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Many of America’s malls have seen dramatic valuation cuts in the last several years. In one example, a mall in Kingston, New York saw its valuation drop to $8.1 million in December, down from $87 million in 2010. And retailers aren’t fairing much better. A March article in the USA Today started with the question: “Is 2017 the death of retail as we know it?” It went on to list more than a dozen national retailers that had, at the time, announced more than 3,300 store closings. Concerns over the future of the brick-and-mortar retail model were raised again in May after several national retailers, having missed their first quarter earnings estimates, saw their stock prices tumble.

But despite recent headlines touting retail’s demise off the back of Q1 earnings, there is a silver lining for the industry. Some high-end mall REITs have begun to find success in moving up-market to fill vacancies created when struggling retail chains have moved out, as well as by cultivating a differentiated shopper experience by incorporating more entertainment, activity and dining venues. These developments indicate the retail model, while changing, is far from dead, which should bolster REITs operating in the sector and willing to innovate.
While REITs face their fair share of challenges in the current market environment, strategic investments could be the key to staying above the fray. With the stock market continuing to reach record-heights, REITs broke a record of their own this year. According to NAREIT, publicly listed REITs raised more than $23.1 billion in equity and debt in the first quarter of 2017—the most capital raised in any quarter since 2014. REITs that take proactive measures to address changing market conditions, prepare for cyberattacks and plan for interest rate increases, will likely be well-equipped to take these risks in stride.