Formerly Overextended REITs Grow Conservative

Conservatism has swept over the real estate investment trust sector, reported Fitch Ratings, New York.

REITs suffered from excess development exposure leading into the 2008-2009 downturn, the ratings agency noted. “REITs [today] are generally less willing to develop new assets at scale and banks have allocated less funding for commercial real estate construction,” Fitch’s U.S. Equity REIT Development report said. “In addition, bank lenders have lowered loan-to-value ratios, requiring borrowers to invest more equity or seek out alternative–often more expensive–lending sources. This has fostered an extended period of favorable supply-demand dynamics and property fundamentals in much of the country well beyond what the typical economic recovery would anticipate.”

Study authors Zachary Klein and Steven Marks said REITs have demonstrated discipline throughout this post-crisis cycle as REITs navigated an environment of historically low-cost debt capital, record-high commercail real estate values and good liquidity positions.

In addition, except for the multifamily sector and ecommerce-focused industrial properties, the recovery has seen only “modest” growth in tenant demand for space, further limiting development opportunities, which tend to expose REITs to more risk than purchasing an existing asset, the report said.

With one clear exception–office REITs–the lack of development opportunity led to mostly level or declining exposures to development costs in recent quarters, Fitch reported. Office REIT exposure to development risk grew “significantly” in the first quarter, almost exclusively due to SL Green Realty Corp.’s $3.3 billion One Vanderbilt skyscraper under development on Manhattan’s east side next to Grand Central Terminal.

The report said REITs will likely gain market share given the current lending environment because banks are growing more reluctant to lend and often require borrowers to invest more equity into projects. In addition, in January 2015, High-Volatility Commercial Real Estate provisions came into effect that require banks to hold additional capital against commercial real estate construction loans on highly leveraged projects. “Accordingly, banks tightened underwriting standards to reflect this change,” Fitch said. “The increased scrutiny on projects and greater asks of the private developers have reduced supply during this upcycle, enabling REITs to benefit more singularly from stronger fundamentals across asset classes.”

Fitch said it considers REIT development exposure in a “manageable” range. “We expect REITs will not deviate meaningfully from current levels,” Klein and Marks said. “REITs have been measured in their external growth with a mix of acquisitions and developments, for which collective costs in this upcycle have often been matched with disposition proceeds, split between joint venture partnerships or funded with common equity issuance.”