Challenging financing conditions and a slowing economy keep our outlook negative.
High-interest rates are causing a multitude of challenges for real estate investment trusts (REITs) and other commercial real estate (CRE) firms.
These include increased funding costs, less liquid real estate purchase/sale transaction markets and lower property valuations.
A decline in interest rates this year would increase transaction activity, but asset values could decline further if a softening economy were to dampen real estate demand.
Falling values will also tighten lending conditions, as banks in certain regions, particularly the US, continue to reduce their CRE exposure, further constraining transactions.
“We expect certain property types and regions to demonstrate greater resilience, but still see risk that credit conditions for CRE firms will further erode,” says Moody’s.
Rental income will remain healthy, but not offset higher capital costs.
Moody’s expects aggregate rental income to grow 1%-3% over the next 12-18 months, which typically reflects a stable outlook.
“But rental growth will not be sufficient to offset the continuing negative impact of high interest rates on the sector, which relies heavily on external capital access and a well-priced real estate transaction market.”
While rates will likely decline this year, they will remain well above historical levels. Therefore, higher funding costs will continue to weigh on earnings as companies refinance lower-priced debt and seek to execute growth initiatives, including acquisition and development activities.
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Net operating income (NOI) growth will continue to slow in the US.
In the US, which represents about three-fourths of our global rated universe, growth will slow across several property types, most notably office and housing.
In office, lower-quality buildings will struggle to maintain occupancy as existing leases expire, while multifamily will face new supply (particularly in some Sunbelt markets) and continued high operating expenses.
For the REITs we rate, which generally own higher quality properties than the broader market, same-store NOI growth (for the 49 rated REITs that report this data) was 3.4% for the fourth quarter of 2023, down from 6.7% in the prior year period.
Excluding healthcare REITs – which grew same-store NOI 7.2% in the Q4 2023 as they continued to recover income lost through COVID – same-store NOI growth was 2.7% versus 5.9% a year ago.
A slowing economy will put more pressure on NOI growth over the next 12-18 months, while operating expenses, including insurance, payroll, and materials costs, will remain high, which will weigh on margins as demand slows.
Capital access is improving, but pullback by US banks adds risks.
CRE firms rely on access to capital in order to refinance debt maturities and fund growth initiatives. This is particularly true for US REITs, which are required to distribute at least 90% of their taxable earnings as dividends to shareholders.
Capital can come from an array of sources, including property sales, common equity offerings, unsecured bond issuance, and commercial lenders, but higher interest rates have made each of these markets more expensive and more difficult to access, which will continue to weigh on credit conditions for US CRE landlords.
European real estate companies face persistent risks and greater credit bifurcation.
The credit quality of European CRE companies is at risk of further deterioration over the next 12-18 months due to higher funding costs, lingering negative pressure on valuations, subdued transaction markets, and a tight funding environment combined with upcoming refinancing needs of cheaper legacy debt.
The sector also continues to face secular challenges such as long-term demand changes for offices, retail, and logistics properties due to changes in work patterns, consumption, and supply chain structures.
However, the impact will vary between asset classes, portfolio quality, and jurisdictions.
Sectors with robust long-term growth fundamentals, like multifamily residential and prime logistics, will see continued rental growth, leading to an earlier stabilization of property values and credit quality.
Conversely, real estate companies with assets in sectors experiencing weaker investor and occupier demand, like non-prime, older office and retail properties, will face more significant negative credit pressure over the next six to 18 months.
Recovery of European investment markets and access to funding remain key.
A weak economic environment and tight funding conditions continue to weigh on European CRE, despite improving sentiment and recovery expectations, and a better interest rate outlook.
With larger refinancing needs ahead, access to bank lending remains crucial for the sector, but stricter lending criteria and a higher marginal cost of debt have weakened refinancing prospects, especially for lower-quality portfolios in challenged property sectors.
While the risk of a funding gap persists, a stronger than expected investment market recovery from a severe contraction, to €162 billion, of transaction volumes in 2023, could facilitate more property disposals.
This would result in a more orderly reduction in leverage and make refinancing risk easier to manage.
“The European CRE market’s recovery will lag behind the UK’s, which is set to recover in the second half of 2024 on the back of lower leverage (see Exhibit 4) and substantial downward adjustment in asset values year-to-date.”
