Fitch: REITs Can Withstand Short-Term Inflation Pressures
Fitch Ratings, New York, said it sees limited risks to real estate investment trust credit fundamentals from a transitory inflation-rate increase, but noted prolonged elevated inflation could pressure REITs.
“Modern equity REITs have successfully navigated a variety of challenging external environments, but REITs remain untested in a sustained inflationary environment,” said Stephen Boyd, Senior Director with Fitch Ratings.
In a new report, U.S. REITs Adequately Positioned to Withstand Transitory Inflation Pressures, Fitch noted the challenging environments that REITs have survived include wars, the dot-com bubble, terrorism, the Great Recession and the coronavirus pandemic. “However, the sector remains untested in a secular interest rate bear market,” the report said. “Drawing conclusions from U.S. REITs’ equity performance in inflationary periods in the 1970s, 1980s and 1990s is inadvisable given the small size and composition of the sector. During these periods the sector was principally comprised of mortgage REITs (i.e., CRE lenders), rather than property owners.”
The report said sustained inflation well above the Federal Reserve’s long-term target could prompt commercial real estate cap rates to move higher. “This could lower property values and create a more difficult refinancing environment,” Fitch said.
Of course, the force behind potential rate increases matters, the report said. “Interest rate increases as a result of stronger economic growth could benefit REIT credits, while a stagflation scenario of higher rates and weak economic growth would almost certainly be negative for REITs,” Fitch said.
A more gradual increase would be better than the “shock to the system” seen in the late 1970s and early 1980s. “This is particularly true for property sectors with longer leases such as triple-net lease, healthcare, retail and central business district offices,” Fitch said.
REITs’ increased use of longer-term fixed-rate debt as opposed to shorter-term variable-rate debt should help buffer their cash flows against higher interest rates. Fitch reported median variable-rate debt equaled 8.7 percent for equity REITs as of June 30, at the low end of the 8.7 percent–17.2 percent range seen over the past 10 years. Hotel REITs have the most exposure to variable-rate debt with 18 percent of total debt. Office REITs had the lowest exposure to variable-rate debt at just 1 percent of total debt.
A sustained increase in interest rates could offset REIT same-store net operating income growth and limit the ability of REITs to grow funds from operations per share, the report said. “REITs may feel pressure to continue to increase common dividends, which could pressure payout ratios and credit quality by extension,” Fitch said.