Top 10 Investor Questions For 2013: Global Real Estate
05-Dec-2012
How does the prospect of a slow U.S. economic recovery affect Standard & Poor's Ratings Services' views on the credit quality of REITs and homebuilders in this market?How does Standard & Poor's account for divergent economic trends in its financial performance forecasts for real estate companies in the Asia-Pacific region? What implications does the prevailing weak macroeconomic environment in Europe have for real estate ratings? What are Standard & Poor's views on the funding outlook for the U.S. real estate sector? What are the most notable debt capital market developments for real estate in the Asia-Pacific region? What are funding conditions like for real estate in Europe? What is your credit outlook for the main property sectors in the U.S.? What is your credit outlook for the main property sectors in Asia-Pacific? What is your credit outlook for Europe's retail and office property sectors?What are the likely prospects for M&A activity in the real estate sector across the three major regions? The global real estate sector is set to finish the year 2012 on a cautiously positive note. Capital real estate values have broadly remained stable, rated real estate investment trusts (REITs) are on track in terms of leasing activity, and most rated developers are seeing improved profitability. The funding environment for rated real estate has improved significantly since 2010-2011, and investor appetite for real estate debt is growing. We're also seeing real estate companies shift toward debt issuance and nonbank funding rather than bank debt--a trend that we believe will continue into 2013. We believe credit quality among our rated portfolio of real estate companies should remain stable into 2013. This is because our base-case operating scenarios for rated estate companies balance macroeconomic headwinds with firms' well-diversified, high quality portfolios.
S&P: Top 10 Investor Questions For 2013: Global Real Estate
While our outlook for global real estate is cautiously positive and highlights rating stability, our expectations and forecasts for the regions and subsectors vary to some degree because of area-specific trends and factors. For example, U.S. apartment and self-storage REITs should lead their market in terms of net operating income growth, while U.S. office REIT performance will lag, largely due to the high unemployment rate. The credit scenario in Asia-Pacific is largely stable for REITs, but property developers will continue to face headwinds because of limited growth prospects. Europe faces similar challenges, largely because of fragile consumer and business confidence, but our rated universe of real estate companies has little or no exposure to the weaker performing economies of southern Europe. In all markets, however, investors and tenants remain very selective, focusing mostly on prime assets and locations and discounting other options.
In this article, we address what we consider the top 10 questions from investors regarding our views on trends in real estate ratings in North America, Asia-Pacific, and Europe.
(Watch the related CreditMatters TV segment titled, "The U.S. Real Estate Industry: Standard & Poor’s Addresses The Top Investor Questions," dated Dec. 5, 2012.)
How does the prospect of a slow U.S. economic recovery affect Standard & Poor's Ratings Services' views on the credit quality of REITs and homebuilders in this market?
We continue to expect the U.S. economic recovery to be slow and uneven, and the impending financial fiscal cliff and potential for financial contagion in the Eurozone elevate the risk to our forecast. In fact, our economists have forecast the odds of another recession at 15%-20%. Nonetheless, we expect the U.S. REIT sector to again deliver same-store net operating income (NOI) growth in the 3%-4% range in 2013. This is because we expect new supply to remain largely contained (amid still tight lending) and tenant demand to strengthen, albeit modestly and unevenly. REITs, with their high-quality portfolios and improved capital positions are well positioned to compete for tenants, in our view, but attractive acquisition opportunities could be limited. As such, we expect financial performance to generally hold steady or modestly improve for the REITs with unique refinancing or investment opportunities.
In contrast, we expect materially improved financial performance for rated homebuilders. After a few false starts, they have finally emerged from the deepest and sharpest downturn since the Great Depression. We estimate the homebuilders we rate generate about 25% of all new home sales in the U.S. For 2013, we are forecasting unit delivery growth in the 20% range, which should put most homebuilders on the path to sustained profits and strengthened debt protection metrics. However, this year's opportunistic debt issuance activity, which many companies largely pursued in anticipation of growth, will slow the pace of expected improvement. The modestly higher debt burdens for some homebuilders could leave them vulnerable to a sudden drop in demand should the recovery underway lose traction.
How does Standard & Poor's account for divergent economic trends in its financial performance forecasts for real estate companies in the Asia-Pacific region?
We have factored a short-term weakness into our economic outlook (compared with our previous 2012 forecast) for Hong Kong, Singapore, and Taiwan. However, we expect that GDP will be stronger in 2013 in these major real estate markets, driven by a rebound in China. The outlook for Australia in 2013 is stable. However, we expect continued weakness in Japan. The REIT sector in Asia-Pacific should stabilize the amount of vacant commercial space through these improving economic conditions, coupled with manageable new supply of space to be leased, low levels of unemployment, and favorable interest rates that will support consumer sentiment. However, while we believe vacancy levels have peaked in Japan, the real estate market will be weighed down by weak economic growth, the reduced external demand from Chinese and European consumers, and the strength of the Yen. We believe that our base-case scenarios and current ratings already factor in these developments, however.
We expect that China will record real GDP growth per annum of about 8.2% over the next two years. As a consequence, we expect that the property developers' current high inventory will be gradually absorbed by pent-up demand. Supply will shrink in 2013 due to a decline in investments in new projects and construction over the past 12 months. Due to sectorwide price-cutting and active promotions since 2011, we believe gross margins and EBITDA margins will remain under pressure for most rated developers. Due to the timing difference between contract sales and recognition of sales proceeds, the negative effect of margins being squeezed on credit metrics will emerge over the next one to two years. Further, increased debt issuance in recent months will further pressure financial metrics; although in the majority of cases, we do not see debt metrics moving outside the range that we consider commensurate with current ratings.
What implications does the prevailing weak macroeconomic environment in Europe have for real estate ratings?
The ongoing recession in most European countries in 2012 is now affecting core countries of the Monetary and Economic Union (eurozone). Our economists expect eurozone GDP to fall by 0.8% this year and remain flat in 2013. Our analysis of the main macroeconomic drivers for the real estate sector views GDP outlook as broadly neutral for the sector. We view high and still rising unemployment rates and stagnant residential mortgage lending and house prices as somewhat unfavorable. Weak construction confidence, although an unfavorable economic indicator by itself, is indicative of low incoming supply of new properties, which benefits established operators. We see very weak economic growth in 2012 and 2013, especially in France and the U.K. We actually expect the U.K. economy to shrink by 0.3% this year before turning back to slender growth in 2013. Based on this view, we estimate a flat to slightly positive rental reversion in the retail and office segments in most European markets, apart from those in southern Europe. The benefit of the rent indexation system in many European markets, whereby rents rise automatically in reference to a consumer price index, will likely be lower in 2012 than in 2011. Indexed rents, however, should remain in positive territory due to our forecast of an average rate of inflation of about 2% in Europe.
Like-for-like rental growth opportunities appear weak in all segments and mostly rely on contractual rent indexation. This leaves leasing activity exposed to marginal new capacity releases. Additionally, over-renting might become a bigger issue than in the past if contractual indexation pushes rents well ahead of market dynamics before leases are renewed. For the issuers that we rate at the investment-grade level ('BBB-' and above), these factors are balanced by a manageable share of rental agreements coming up for review in any one year, and by relatively low exposure to individual tenants and pockets of economic activity. We consider that our base-case operating scenarios for rated issuers already incorporate these risks, which are reflected in the ratings. Our base-case assumption for our real estate portfolio is flat revenue growth in 2013, with low single-digit recovery in 2014. Our alternative scenario is for slightly negative year-on-year revenue growth in 2013 and flat revenue in 2014. Importantly, our rated universe of real estate companies has little or no exposure to the weaker-performing economies of southern Europe.
What are Standard & Poor's views on the funding outlook for the U.S. real estate sector?
U.S. real estate companies have enjoyed strong access to the capital markets since the start of 2012. Through the first three quarters of 2012, REITs and real estate operating companies (REOCs) issued $20 billion of rated debt and preferred stock to refinance existing obligations and fund acquisitions. Over the same period, U.S. homebuilders have issued $6 billion for refinancing and to fund growth as the housing sector continues to mend. In total, we think 2012 debt issuance will exceed the level we saw at the 2006 market peak.
REITs and homebuilders have been able to lower average cost of debt thanks to this recent round of refinancing activity, and the activity has lengthened debt tenors. REITs have also issued an equivalent amount of common equity to reduce or preserve lower leverage levels. We believe REITs will continue to access the equity market through underwritten offerings and the use of established equity programs to fund investments and maintain or further reduce leverage. In general, we believe U.S. REITs are well positioned to manage their businesses (which are enjoying mostly stable-to-improving fundamentals), be opportunistic on the M&A front and manage through any potential slowdown in the capital markets due to very manageable debt maturities. For homebuilders, we see investment needs growing, so access to capital will remain critical. While debt maturities are fairly light for the sector in 2013, they will be heavier in 2014 and 2015.
What are the most notable debt capital market developments for real estate in the Asia-Pacific region?
REIT managers have taken a disciplined approach toward acquisitions by purchasing assets that meet their investment criteria and provide stable rental income. REITs have significantly increased their debt issuance because of the relatively higher borrowing cost and shorter-term funding from banks. The total debt issuance by Asian REITs/REOCs year-to-date is US$6.4 billion. As capital requirements and regulations become tighter for banks in 2013, the funding environment will continue to favor the debt capital markets, and issuers will be looking to lock in longer-term funding at attractive interest rates. Support for the REITs is evidenced by the recent spate of Australian domestic medium-term note (MTN) issuance. The Asian REIT sector has replaced more expensive bank debt with fixed-rate debt for periods of five, seven, and up to 10 years. The 10-year funding is a first for the Australian market. In Hong Kong and Singapore, many large property companies tapped the bond market for the first time in 2012 and increased their debt mix toward more favorable funding costs and terms in the bond market.
It has also been a busy year for Chinese developers in terms of bond issuance. Nearly half of 32 publicly rated developers issued bonds and raised close to US$10.7 billion. Some of the stronger developers in our rated universe (those rated in 'BB' and above) have issued bonds at lower coupon rates compared with previous issuance as investors' appetite increased on abundant liquidity and an improving market outlook. Offshore funding, particularly from the bond investors, offer developers longer-term funding compared with what they could get in the on-shore market, and for some, the funding cost could be lower. For example, China Overseas Land & Investment Ltd. (BBB/Stable/--) and SOHO China Ltd. (BB+/Negative/--) have issued US$1 billion in five- and 10-year bonds in the past month at coupons that are below the on-shore borrowing cost.
What are funding conditions like for real estate in Europe?
Funding conditions remained positive for publicly listed real estate corporates in the second and third quarters of 2012, as pricing for 'BBB' category bonds stayed within our expectations and were comparable with other industry sectors. New issuance at the 'BBB-' level got off to a strong start in the third quarter of 2012, with debut bond issues from Foncière des Régions (BBB-/Stable/A-3) and Prologis European Properties Fund II FCP (PEPF II; BBB/Stable/A-2). Investor sentiment toward the sector has visibly improved in the past 12 months, and a number of companies have benefited by tapping less-traditional funding sources such as loans from nonbanking institutions and a wider range of privately held debt instruments. Year-to-date rated European real estate companies have issued US$6.7 billion in debt.
We believe that any improvement in real estate credit quality will likely remain limited over the next two years, primarily because of the uncertainty surrounding an economic recovery in Europe. That said, companies with high-quality, diversified property portfolios (typically worth in excess of €2 billion) should retain a good degree of control over their leasing risks. This development might go half-way to meet increasing appetite for real estate exposure on behalf of European investors seeking wider spreads in a low interest-rate environment. Refinancing risks for property companies with loan-to-value ratios of materially less than 60% also remain moderate, in our view, although the limited exposure of these companies to investors, and ability to bring benchmark-sized issues to market, will continue to constrain their transition to more diversified funding structures from mainly secured bank financing.
What is your credit outlook for the main property sectors in the U.S.?
For U.S. REITs, we expect tenant demand for space to remain modestly positive and new supply to remain limited, resulting in absorption of vacant space across all subsectors, with the exception being suburban office, which will remain challenging in a high unemployment scenario. We expect absorption for suburban office to be flat to modestly positive. The outlook reflects our belief that occupancy and rent for all sectors will continue to gradually improve through 2013. Apartment and self-storage have been sector leaders in growth in NOI, followed by factory outlet centers and dominant malls. However, the apartment sector is beginning to lose some steam as the pace of rent growth is slowing in some markets--a trend we believe will continue in 2013. We expect self-storage to eclipse apartments as the sector leader in 2013, although the apartment sector should continue to generate positive same store growth. We expect the strip center retail and industrial subsectors to improve, but at a slower pace. The steady health care subsector should continue to produce stable to mid-tier same-store growth. Although this acquisitive sector is likely to remain opportunistic, we are not forecasting the same level of M&A in 2013. We believe office will lag--with suburban office in particular to remain challenged into 2013, although we believe suburban office has troughed and should show slow gains in 2013.
Should the nascent U.S. housing market recovery continue to pick up steam (we are expecting a steady recovery) the retail, storage, and industrial subsectors would benefit. We believe a more robust housing recovery might spur demand growth beyond the 2.3% GDP improvement that our economists have forecasted for 2013, aiding recovery in the lagging office market.
What is your credit outlook for the main property sectors in Asia-Pacific?
Our credit outlook for the 42 Asian REITs is largely stable and these companies are firmly anchored in the investment-grade category. Their operating and financial trends are largely satisfactory, which are reflected in the fact that the majority of our rated entities have a stable outlook. Despite the short-term economic headwinds in the major Asian markets, the REITs maintain a well-spread leasing maturity profile and diverse tenant base, both of which reduce volatility in cyclical leasing markets. Our rated portfolio also contains a solid asset base that benefits from low vacancy rates and attractive rental space when compared with the whole market.
The credit outlook for the 32 Chinese property developers is still negative, but it has improved from six to 12 months ago. Housing prices continued to increase modestly in October 2012--the fifth consecutive month of growth. Transaction volume stabilized following the recovery in second to third quarters. However, we maintain our negative bias because property sales have improved in 2012 from a low level. Out of 50 ratings that we have in this segment, 44% have a negative outlook, with the rest on stable outlook and one rating on CreditWatch positive. This is because the prospects for strong growth are limited as the economic outlook is subdued, which dampens purchasing power and investment sentiment. Moreover, the administrative control on property investment and speculative sales will continue to restrain housing prices. The financial strength of most developers may take time to recover due to weaker profitability as many have cut prices in the past 12 months to clear inventory while continuing to increase their borrowing, albeit at a slower rate, to fund expansion.
What is your credit outlook for Europe's retail and office property sectors?
Over the past 12 months, consumer confidence in Europe has dipped below its historical average as prospects for an early economic recovery receded amid the sovereign debt crisis. We believe rising unemployment and lower disposable incomes due to government austerity measures and job cuts in the corporate sector will continue to weigh on consumer confidence. Demand remains muted across the eurozone: on average, retail sales fell 1% year-over- year in the first half of 2012.
Divergence between countries, however, is increasing. We anticipate positive rental prospects for retail properties in Germany, France, and Poland, flat performance in the U.K., and a decline in rental growth in southern European countries. The Nordic region and major emerging markets such as Russia and Turkey are continuing to show more positive trends for retailers. Investors and tenants remain very selective in all markets, however, and are focusing mostly on prime assets and locations and disregarding other options. With a relatively low supply of new space expected in Western Europe over the next two years, we believe rental levels are unlikely to decline sharply next year, especially in the prime quality shopping malls, which have attracting retail foot traffic away from secondary locations.
Corporate consolidation and rationalization continues to drive the slow take-up in the European office property sector, often resulting in surplus space being released into the market. This, combined with the fact that speculative development is largely on hold in many cities, has led to a steady deterioration in the quality of vacant property, which has benefitted larger established real estate companies. We believe rental growth will remain subdued. Any increase that may emerge through economic recovery will likely be driven by the scarcity of prime space in central business districts.
What are the likely prospects for M&A activity in the real estate sector across the three major regions?
Asia-Pacific REITs have been acquiring assets over the past 12-18 months to capitalize on the low and declining cost of debt relative to the net operating income yield from the assets they've acquired. So far, there have been few sizeable debt funded mergers and acquisitions. It appears that REIT managers have taken a more cautious approach to debt-funding since the financial crisis in 2008, and many of the weaker REITs have not restored their financial profiles. Australia and Japan are fertile grounds for M&A activity. Singapore-based REITs are also purchasing assets to enhance their portfolio yield. Japan-based REITs have made acquisitions, often from their sponsors, to increase their distributions to unitholders. We believe this trend will likely continue as interest rates remain low.
In China, we expect the polarization of strong and weak developers will continue and that industry consolidation will continue for the next 12 months. The year's M&A highlight was the partial sale of luxury homebuilder Greentown China to Hong Kong landlord Wharf Holdings Ltd. The pace of M&A is slowing as the property market stabilizes and recovers. However, the pace of asset sales will unlikely slow for developers at the low end of our rating spectrum (those rated 'B+' or below) as they continue to struggle with weak sales and burdened by high debt leverage. Companies remained opportunistic in land acquisition and expansion during the recent market correction, which precludes a meaningful deleveraging for Chinese developers in the next 12 months. When sales are strong, Chinese developers tend to purchase land aggressively. When sales are weak, many choose to preserve cash rather than pay down debt.
M&A activity for the rated U.S. REIT sector has not been particularly robust this year. We have seen pockets of M&A activity in the health care sector, as the three largest health care REITs (HCP Inc., Ventas Inc., and Health Care REIT Inc.) picked up where they left off in 2011 by using their low costs of capital to expand their platforms. M&A among the publicly listed real estate companies was modest and limited to Ventas Inc.'s acquisition of medical office owner Cogdell Spencer Inc. and Realty Income Corp.'s announcement that it will a acquire American Realty Capital Trust Inc..
Some REITs have expanded their footprints outside the U.S., possibly due to the competitive pricing for good quality real estate in the U.S. Health Care REIT expanded into the Canadian market, partnering with a large Canadian-based senior housing operator. We had previously seen Tanger Factory Outlet Centers Inc. and Simon Property Group expand their retail platforms into Canada.
Moving even further from the U.S. border, in 2012 a few U.S.-based REITs reached over the Atlantic to make investments in Europe. Simon led the way, re-entering the European retail market by opportunistically acquiring a 28.7% stake in publicly traded Klepierre S.A. for $2 billion as BNP Paribas, its largest investor, looked to monetize a portion of its ownership stake. Lastly, perhaps looking for yield given aggressive pricing in the U.S., BioMed Realty Trust Inc. invested $197 million to acquire fully leased laboratory and office buildings in Cambridge, U.K., and HCP Inc. invested $215 million in the senior unsecured notes of a large elderly and specialty care provider in the U.K. with a coupon rate in excess of 12%. We do not foresee or forecast material M&A activity in 2013 for U.S.-based REITs given frothy pricing for real estate. However, we continue to expect similar opportunistic pockets of activity, given the fragmented nature of U.S. real estate ownership and the low cost of capital that REITs currently enjoy.
The same holds true for European REITs, which have engaged in few major transactions in 2012. Unibail-Rodamco (A/Stable/A-1) bought Germany's second-largest shopping center owner mfi AG (not rated). This transaction was by far an exception to other REITs' approach, which has favored marginal churning of assets in the portfolio over acquiring other real estate companies. In the office sector, demand from insurance companies for high-quality buildings with long-term tenants, has given REITs marginal opportunities to release capital through the sale of buildings and re-invest it into potentially better income-generating properties. Large investors, such as pension funds, sovereign wealth funds, and insurers are mostly interested in large retail assets, which we believe should continue to support capital values in the European retail property segment.
Asia Pacific Contacts:
Christopher Lee, Hong Kong (852) 2533-3562;
christopher_k_lee@standardandpoors.com
Craig W Parker, Melbourne (61) 3-9631-2073;
craig_parker@standardandpoors.com
EMEA Contacts:
Anna Overton, London (44) 20-7176-3642;
anna_overton@standardandpoors.com
Franck Delage, Paris (33) 1-4420-6778;
franck_delage@standardandpoors.com
U.S. Contacts:
Lisa Sarajian, New York (1) 212-438-2597;
lisa_sarajian@standardandpoors.com
George Skoufis, New York (1) 212-438-2608;
george_skoufis@standardandpoors.com
Top 10 Investor Questions For 2013: Global Real Estate
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