In one sense, DBRS Morningstar's advice that tenant quality is important in a recessionary environment is straightforward. Tenant quality is always an issue when trying to understand the financial strength of an investment of development project in any part of CRE.
Upward pressure on prices and downward pushes on cap rates have all been justified by the anticipation of future rent growth. All that depends on whether the tenant remains in business and capable of sustaining increases in expenses.
"Tenant quality is an indicator of future cash flow stability for real estate entity issuers, especially in a recessionary environment, and the current rising interest rate environment is leading market participants to wonder if (or when) a recession could be arriving," the firm wrote.
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That means more pressure on tenants, who have non-rent expenses more likely to feel the direct impact of increased financing costs and also customers that are affected, potentially cutting their purchasing plans as a result.
According to the credit rating agency, the outlook for the CRE entities it rates are largely stable. "DBRS Morningstar-rated issuers generally have high exposure to investment-grade (IG) rated tenants or tenants related to IG parent companies, which should maintain stable cash flows throughout tenants' respective lease terms," the firm wrote, adding, "the average aggregate default rate of DBRS Morningstar-rated global corporate entities between 1976 and 2021 (excluding discontinued ratings) was 1.88% for the BBB-rated category, a stark difference from the 6.43% default rate for the BB-rated category."
Much of the DBRS Morningstar rating approach uses a top-10 tenant, based on rental revenue, for each issuer. Of these, 65% broadly are investment grade (IG), another 7% has an IG corporate parent, 8% are non-IG, and 20% have no public rating.
The issuers run the gamut of pension fund REOCs, retail REITs/REOCs, industrial REITs/REOCs, office REITs, and diversified REITs., with the first being the most risk-adverse, and so with the largest concentration of high-quality tenants.
Though the approach does raise a question. There is more than one way that tenants, even IG ones, can become a problem. Although they may have the financial stability to weather an economic storm, they might decide to reduce costs. A good example is KPMG, which after announcing that it would relocate from one part of Manhattan to another then let the other show drop: It would shrink its office space by 40%.
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