S&P's Managing director of real estate ratings, Lisa Sarajian, says that "while other markets have been extremely volatile, REITs have held up remarkably well relative to other benchmarks." She attributes the comparatively positive performance of REITs so far to their "stable and defensive cash flows due to underlying contractual leases of varied duration and asset type."

Debt refinancing needs of S&P-rated firms also have remained manageable despite economic downturns. "The right side of the balance sheet is also in pretty good shape," Sarajian says. "REIT equity so far is holding up and external liquidity remains sound."

But REITs are nevertheless an undependable barometer of future real estate market trends, she says, because they are too far up the food chain. And with no economic recovery in sight, REIT portfolios have no surety of remaining safe financial havens. "It is clear that REIT earnings are lagging indicators and ultimately they'll be tethered to the credit quality of their rent-paying tenants, so the longer and deeper the expected recession proves to be, the more negative our bias for current ratings will become."

Sarajian says that while "some property sectors and geographic markets are going to be more immediately vulnerable than others in the current environment," three areas will be heavily scrutinized by S&P in the coming months:

Non-essential retail--regional-malls and entertainment-oriented projects.
Companies with largely unleased development pipelines
Issuers more highly dependent on capital recycling to meet their longer-term funding needs

And while S&P believes that "most portfolios are large enough to offer some meaningful pooling benefits as well as moderate geographical diversity," down the road "a number of factors could serve to chip away at these strengths." The ripple effect of recently announced job layoffs, Sarajian says, could mean trouble for REITs "attempting to deliver newly developed but largely unleased properties.

While not all property sectors will be affected to the same degree or in the same way, S&P believes that all markets will face challenges both in the near and longer terms:

Retail properties catering to nondiscretionary spending are expected to fare relatively well, but operating and financing costs will rise for larger retail properties and those that are more entertainment-focused.
Apartment and manufactured home communities will contend with expected layoffs, falling rents and rising delinquencies.
Office and industrial portfolios will continue to benefit from long-term leases and good-credit tenants, but demands for greater workplace security, locations preferences and retooling of business models will affect operating costs.
Stand-alone retail properties will become even more dependent on the health of the primary tenant because strong locations are now offset by a dwindling pool of replacement tenants.
Health care-oriented and self-storage properties will benefit from the more essential services provided (health care) and the comparatively low break-even occupancy requirements (storage).

She stresses, however, that much more time will pass before any meaningful analysis of the impact that the bombings will have on REITs. "It's only three weeks since September 11 and we do not believe we can easily extrapolate the future based upon very recent post-attack trends," she says. "We're following north of 70 companies, so clearly we'll continue to take a company-by-company approach to monitoring events over the next couple of months.

Instant Insights /

REITs Still Strong but Long-Term Outlook Remains Foggy

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