Lending Metrics to REITs Paint a Mixed Picture

As a recent Trepp report reminds, REITs have had some challenging times of late because inflation and recession fears caused investors to take dimmer views of commercial real estate values.

“So far in 2023, REIT share prices have rebounded, but they are still down by 12% versus prices a year ago. Additionally, private REITs have been facing substantial investor withdrawals, so much so that they have had to implement limits on how much can be taken out.”

And so, the firm decided to profile the REIT sector by looking at how lending institutions have treated the entities. Trepp examined and various factors of commercial and industrial (C&I) loans to real estate lessors. Although that category is larger than REITs, it should have a close relationship with the more specific class and so act as a proxy.

Interest rate increases have limited the amount of borrowing such organizations would be willing to undertake, which explains part of a drop in the overall real estate lessors use of loans. Previous to the pandemic, the loan utilization rate appears to have hovered between 51% and 53%. It spiked to nearly 63% by March 2020, sunk into the upper 40s in 2021, and then rebounded to about 51% by March 2022, only to drop below 50% by the end of that year. The reason, Trepp suggests, is concerns over the economy and potential of a recession, making REITs reluctant to fully extend themselves in the face of uncertainty.

Standard financial ratios for those C&I loans have also improved. With returns on both assets and equity up from higher interest rates, and inflation helping return on assets, the interest coverage ratio has grown from roughly 2.3% or 2.4% up to nearly 3.1% by the end of 2022 Q3.

And debt-to-equity has fallen from the approximately 0.820 to 0.840 range to the most recently compiled ones of about 0.73.

Then comes something a bit more curious. The risk rating information on all C&I loans to real estate lessors, in a one (best possible rating) to nine (default) range, has seen a significant drop in the percentage of poorer loans — those rated 6 and above — from 12.14% in the fourth quarter of 2020 to 4.24% in the third quarter of 2022. But the average risk rating hit the highest figure since the first quarter of 2021.

“Solid income, conservative interest coverage, and steady loan performance reinforce that conditions are still healthy within this sector,” Trepp wrote. “Borrowers are exercising more discipline in regard to borrowing, partly because income is rising faster than their interest payments. However, lenders have shifted to a defensive footing, as exhibited in the decrease from some of the least risky rating categories.”